Evaluation of Target-Date Glide Paths within Defined Contribution Plans

Abstract

We present a simple methodology to support sponsors of defined contribution (DC) plans when evaluating the allocation to equity in target-date glide paths. Generally, the investment objective of a DC plan is twofold: accumulation of wealth prior to retirement and conversion of wealth to income during retirement. While wealth accumulation is fairly unambiguous, income generation depends on the intended horizon. In particular, sponsors face two primary considerations related to this horizon. The first is the ability of a glide path to generate lifetime income consistently over the course of retirement, while the second is the ability of the glide path to limit the risk of capital loss near and during retirement, which is particularly important for participants who withdraw their balances over a more moderate-term horizon. As one might expect, these considerations tend to be at odds with each other because while the long-term growth prospects of equity can enhance a portfolio's ability to generate lifetime income, its market volatility leads to greater variability in account balances, which can impair the ability to recover peak balances when withdrawals occur over shorter horizons. Thus, the challenge of glide path selection is really one of striking a compromise between these two competing goals. This compromise cannot be achieved via objective analysis alone and must also be informed by the subjective horizon and risk preferences of the sponsor acting as an agent for the plan participants. Two employers that each offer a DC plan with similar participant demographics and employee benefits may quite rationally select different glide paths because of different preferences. In our research, we find that higher-equity glide paths offer greater efficacy for lifetime income replacement, while lower-equity glide paths offer greater efficacy for stable account balances with lower risk of large capital losses. Directionally, these conclusions hold over a wide range of plan characteristics and assumptions, although the relative magnitude of the trade-off depends on characteristics unique to each plan.

Keywords: Defined Contribution, Target-Date Funds, Glide Path, Retirement

JEL Classification: E21, G11, J26