TARGET DATE

Measure how well a target date fund has surfed the highs and lows

KEY TAKEAWAYS

    • QDIA offerings should aim to deliver outcomes desired by a broad group of participants
    • Target date funds that illustrate both favorable appreciation and preservation characteristics may fit that bill
    • Capture ratio analysis can help determine who those providers are

    Target date funds have proliferated in the defined contribution market and are now frequently used as qualified default investment alternatives (QDIAs). Evaluating such investments, which have multiple objectives, can be challenging. For example, how can we know if a target date fund that works for young participants also works for those nearing retirement?

     

    The need to serve changing objectives in one offering makes target date funds fundamentally different than other investments — and calls for a different measurement tool.

     

    Financial professionals and consultants use upside capture ratio to gauge how fully a fund has participated when markets appreciate. Upside capture is a measure of how well a fund did relative to equity markets (usually measured by the S&P 500 Index) during periods when the index has risen. When markets decline, a comparable measure — downside capture ratio — is used to measure how well the fund limited losses compared to the index.

     

    How well do these measures work for target date funds, where balance between appreciation and preservation is important? Successful target date funds, like surfers, must ride the strong market waves without wiping out when the surf eventually crashes.

     

    To evaluate how effectively a target date fund has achieved that balance, consider dividing the upside by the downside capture. The result — the overall capture ratio — may measure how well a fund balances building and preserving wealth.

    In this illustration, an upside capture ratio of 97 relative to the benchmark of 100 means the fund delivered all but 3% of the benchmark’s appreciation, while a downside capture ratio of 95 relative to the benchmark of 100 means the fund was exposed to all but 5% of the benchmark’s declines. In this case, the quotient of 97 divided by 95 gives the fund an overall capture ratio of 1.02 relative to the benchmark of 1.00.

    The hypothetical fund in this example gained about 3% less than the S&P 500 when the market rose, but dropped 5% less when the market fell. In this case, the quotient of 97 divided by 95 gives the fund an overall capture ratio of 1.02 relative to the benchmark of 1.00. Thus, it did a good job of balancing the market’s waves. The overall capture ratio encapsulates this.

     

    Balance is especially important for target date investors because volatility is magnified when participants withdraw money as they retire or leave a plan. Considering participants are motivated 2 to 1 by losses over gains, losing less than the market during downturns can help keep participants centered.*

     

    On the other side, with longer life expectancies there’s a real risk that participants will outlive their savings. So target date funds must also be able to provide meaningful upside participation when equity markets do well. The need to build and sustain a retirement nest egg means the keys to investing apply to target date funds as well.

     

    The following infographic shows how the best upside and downside funds may not be the best funds for balancing market and longevity risk. Of the three target date series shown, Fund A didn’t have the best upside or downside capture ratio, but it had the best overall capture ratio. Bear in mind this example is only an illustration. Actual target date funds are divided into “vintages” based on the specific number of years before the target date — usually age 65 — is reached. Results can vary greatly across vintages.

    This illustration first plots the upside capture ratio, then the downside capture ratio, and finally the overall capture ratio for six target date vintages (2055, 2050, 2045, 2035, 2030 and 2025) against the Morningstar category average. It shows that different series had the highest upside and lowest downside capture ratios. A third series, which had neither the highest upside nor the lowest downside capture ratio, had the best overall capture ratio. For Series A, the upside capture ratio was 100.8 for the 2055 vintage, 102.9 for the 2050 vintage, 102.7 for the 2045 vintage, 107.2 for the 2040 vintage, 107.7 for the 2035 vintage, 107.5 for the 2030 vintage, and 105.2 for the 2025 vintage. For Series B, the upside capture ratio was 94.5 for the 2055 vintage, 93.4 for the 2050 vintage, 89.3 for the 2045 vintage, 88.1 for the 2040 vintage, 86.9 for the 2035 vintage, 90.2 for the 2030 vintage, and 93.4 for the 2025 vintage. For Series C, the upside capture ratio was 103.4 for the 2055 vintage, 104.0 for the 2050 vintage, 104.5 for the 2045 vintage, 107.1 for the 2040 vintage, 107.3 for the 2035 vintage, 104.0 for the 2030 vintage, and 100.6 for the 2025 vintage. For Series D, the upside capture ratio was 101.9 for the 2055 vintage, 104.1 for the 2050 vintage, 104.7 for the 2045 vintage, 108.1 for the 2040 vintage, 109.1 for the 2035 vintage, 114.3 for the 2030 vintage, and 116.9 for the 2025 vintage. For Series A, the downside capture ratio was 93.5 for the 2055 vintage, 94.5 for the 2050 vintage, 94.2 for the 2045 vintage, 97.8 for the 2040 vintage, 97.8 for the 2035 vintage, 96.9 for the 2030 vintage, and 93.8 for the 2025 vintage. For Series B, the downside capture ratio was 91.6 for the 2055 vintage, 90.0 for the 2050 vintage, 86.5 for the 2045 vintage, 84.9 for the 2040 vintage, 83.9 for the 2035 vintage, 86.5 for the 2030 vintage, and 89.3 for the 2025 vintage. For Series C, the downside capture ratio was 105.7 for the 2055 vintage, 106.1 for the 2050 vintage, 107.0 for the 2045 vintage, 108.7 for the 2040 vintage, 108.5 for the 2035 vintage, 105.1 for the 2030 vintage, and 97.4 for the 2025 vintage. For Series D, the downside capture ratio was 97.3 for the 2055 vintage, 98.9 for the 2050 vintage, 99.7 for the 2045 vintage, 102.5 for the 2040 vintage, 103.7 for the 2035 vintage, 107.7 for the 2030 vintage, and 109.4 for the 2025 vintage. For Series A, the overall capture ratio was 1.08 for the 2055 vintage, 1.09 for the 2050 vintage, 1.09 for the 2045 vintage, 1.10 for the 2040 vintage, 1.10 for the 2035 vintage, 1.11 for the 2030 vintage, and 1.12 for the 2025 vintage. For Series B, the overall capture ratio was 1.03 for the 2055 vintage, 1.04 for the 2050 vintage, 1.03 for the 2045 vintage, 1.04 for the 2040 vintage, 1.04 for the 2035 vintage, 1.04 for the 2030 vintage, and 1.05 for the 2025 vintage. For Series C, the overall capture ratio was 0.98 for the 2055 vintage, 0.98 for the 2050 vintage, 0.98 for the 2045 vintage, 0.98 for the 2040 vintage, 0.99 for the 2035 vintage, 0.99 for the 2030 vintage, and 1.03 for the 2025 vintage. For Series D, the overall capture ratio was 1.05 for the 2055 vintage, 1.05 for the 2050 vintage, 1.05 for the 2045 vintage, 1.05 for the 2040 vintage, 1.05 for the 2035 vintage, 1.06 for the 2030 vintage, and 1.07 for the 2025 vintage.

    Are you using the right measurement for target date funds?

     

    Target date funds are fast becoming the primary retirement vehicle for many American workers, but investors often lack the proper tools to evaluate how well these funds contribute to participant outcomes. In combination with other factors, overall capture ratios may help measure the effectiveness — and desirability — of a target date series over time.

    Rich Lang is a multi-asset investment director at Capital Group. He has 30 years of investment experience (as of 12/31/2023), all with Capital. He holds master's and bachelor's degrees from Loyola Marymount University.

    Past results are not predictive of results in future periods.

     

    * Daniel Kahneman and Amos Tversky. “Advances in Prospect Theory: Cumulative Representation of Uncertainty,” Journal of Risk and Uncertainty, October 1992.

    Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.
    Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses and summary prospectuses, which can be obtained from a financial professional and should be read carefully before investing.
    Although target date portfolios are managed for investors on a projected retirement date time frame, the allocation strategy does not guarantee that investors' retirement goals will be met.
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