How costly is it to ignore interest rate risk management in your 401(k) plan?

This paper explicitly derives and explores optimal interest rate risk management for lifecycle investors in DC pension plans, and compares our results to the portfolio mix chosen in practice by Target-Date Fund (TDF) managers. We show that investments in long-term bonds play an important role in the portfolio of middle-aged individuals between ages 45 and 70. Our theoretical findings stand in sharp contrast with the investment choices made in practice; the role of long-term bonds is rather limited in the investment portfolios of 401(k) pension plan members in the US. Morningstar data on TDFs points out that the average bond duration is limited to five years and does not depend on age. We find that the absence of long-term bonds in the portfolio of a lifecycle investor can be costly, with the welfare loss peaking at 5 percent of consumption for middle-aged individuals.