The Foundation of Target-Date Funds and Annuities

May 2017

Target-date funds help hedge financial market risk, but these funds don’t lessen the risk of outliving your savings.

Summary

Target-date funds, which offer age-dependent combinations of equity and bonds, can be introduced into annuitized investing to cover a larger spectrum of risk. An investor who owns a variable annuity whose notional value adjusts with market movements can hedge financial market risk while also fully insuring idiosyncratic mortality risk. In this study exploring the interplay between target-date funds and annuitization, the author examines the optimal location of annuitized investing and where to locate equity and bonds within such contexts.

Key Insights
Financial/portfolio risks and mortality risks are independent and separable, so holdings including annuities can capture both completely.
The target-date funds framework without annuities does not allow someone with a limited bequest motive to insure idiosyncratic mortality risk.
The study’s results support the use of target-date fund products within annuitized vehicles.
Methodology

Assuming the proportion of target-date funds invested in equity strictly declines with the investor’s age and that market risk and mortality risk are independent, the author exposits three propositions: 1) a linear combination of two target-date funds spans the feasible allocations of bonds and equity and replicates any other target-date fund; 2) the capital asset pricing model is equivalent to the mean-variance efficiency of any target-date fund; and 3) target-date funds offered inside an annuity wrapper should mirror those offered outside the annuity.