The Role of the Equity Risk Premium in the Shortfall Risk of Target-Date Funds

Max B. Kalman


Target-date mutual funds are seen as a simple way of investing over a certain time horizon because the investor is uninvolved in the mechanics of the asset allocation process. These particular mutual funds stimulate a unique advisory relationship between the investor and the fund manager because the manager’s responsibility is multifaceted. Primarily, the manager will maintain the correct asset allocation without need for intervention from the investor, which results in two implications for the chosen portfolio: the asset allocation is assumed to be correct, and the asset allocation is assumed to be an efficient allocation from a risk-return perspective. The manager will maintain an efficient allocation by gradually reducing the fund’s exposure to equities over time in order to decrease the risk of the portfolio as the target retirement date nears. Using a bootstrap simulation, this paper assesses the shortfall risk (probability of running out of money) of target-date funds and self-managed portfolios during retirement. This analysis uses forward-looking equity risk premiums rather than relying on historical equity risk premiums in order to develop forecasts for the future. One must consider the effectiveness of the asset allocation strategy for the target-date fund in comparison to an investor’s self-managed constant allocation. Bootstrapping simulations with various adjusted equity risk premiums illustrate that a target-date fund has a higher probability of running out money than a fixed 50/50 stock/bond portfolio. In conjunction with the results of previous studies, this analysis suggests that these funds may need to reconsider their asset allocation strategies irrespective of market conditions.


Shortfall, Bootstrap, Equity Risk Premium

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