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.

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.

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.

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