Target-Date Funds’ Distorted Investing Strategy: Research Affiliates

So, prior to any distributions from target-date funds, the average retiree already derives most of his income from fixed-income sources to which millennials lack access.

Millennials, on the other hand, have a wealth of human capital, which the Research Affiliates researcher likens to stocks because this asset increases slightly faster than inflation over the long term but can suddenly diminish or disappear during a recession.

Moreover, millennials are typically saddled with debt based on the investments they have made in a college education or in buying a first home.

As they progress through life, workers pay down these debts, "in effect buying back their own bonds and deleveraging their balance sheet," Beck writes. "Retirees generally have very little debt remaining; some even have none left at all and live rent- and mortgage-free in their own home. Should boomers that are buying down their debt also be compelled to buy additional debt securities (a.k.a., bonds) in a TDF?"

The conventional wisdom embedded in TDFs therefore urges the young, who are naturally invested in stocks (through their human capital) to buy more stocks while inducing bond-heavy (through Social Security and pensions) retirees to buy more bonds.

"If the conventional goal is to have a riskier balance sheet as a young adult and a safer one as a senior, then that goal has already been accomplished outside one's DC plan. For many investors, the glidepath to retirement is already in place," Beck writes.

That natural glidepath consists of an equity-like portfolio for the young, a balanced portfolio for mid-life and a fixed-income portfolio for retirees.

With that glidepath naturally in place, millennials and boomers—ironically—should be investing the balance of their portfolios more similarly than the TDF concept suggests.

"Baby boomers who expect to receive 40% of their retirement income from bond-like sources such as Social Security and defined benefit distributions might consider dividing their remaining assets more or less equally among mainstream stocks, mainstream bonds, and a third pillar of inflation-hedging assets such as TIPs, high-yield bonds and low-volatility equities," Beck recommends.

That is quite similar to Arnott and Wu's recommended "starter portfolio" for the young, which they would allocate in equal thirds to stocks, bonds and "diversifying inflation hedges" (which include TIPS, low-volatility equity, high-yielding bonds or moderate amounts of REITs and emerging market stocks and bonds).