How to Design Target-Date Funds?

Abstract

Several years ago, the concept of target-date funds emerged to complement traditional balanced funds in defined-contribution pension plans. The main idea is to delegate the dynamic allocation with respect to the retirement date of individuals to the portfolio manager. Owing to its long-term horizon, a target-date fund is unique and cannot be compared to a mutual fund. Moreover, the objective of the individual is to contribute throughout their working life by investing a part of their income in order to maximise their pension benefits. The main purpose of this article is to analyse and understand dynamic allocation in a target-date fund framework. We show that the optimal exposure in the risky portfolio varies over time and is very sensitive to the parameters of both the market and the investor's. We then deduce some practical guidelines to better design target-date funds for the asset management industry.

Keywords: target-date fund, retirement system, dynamic asset allocation, stochastic optimal control, market portfolio, risk aversion, stock/bond asset mix policy

JEL Classification: C61, D91, G11, J26