Over the course of the last 12 months, concerns have been voiced at Department of Labor and Securities and Exchange Commission hearings, and by Sen. Herb Kohl (D-Wis.), chairman of the Senate Aging Committee, about whether plan sponsors and participants understand the underlying assumptions and risk associated with target-date funds.

But for the most part, providers are staying the course and not making any major changes to the asset allocations of their target-date funds, say consultants. "As you look at these funds today, relative to where they were a year ago, there really hasn't been dramatic change," says Phil Suess, a partner with Mercer.

Guaranteed income

Nonetheless, the financial crisis of 2008-2009 shed some light on the potential volatility of target-date funds, particularly as plan participants near retirement. "2008 was an important turning point for these funds in particular because, for a lot of people, it was a nasty surprise that many of these funds that had 'retirement' in their title took significant losses," says Buck Consultants' Leon Travis. "It was eye-opener for participants and plan sponsors."

Some in the industry expect to see more providers begin introducing some type of guaranteed component to their target-date funds to help deal with volatility.

"The industry's next solution to address the volatility issue is wrapping a target-date fund with a lifetime income-guaranteed living-withdrawal-type benefit product," says Charlie Nelson, president, Great-West Retirement Services. "A participant can enjoy the upside in the market but have some downside protection as well."

It's a marriage between target-date funds and annuity-type products, so that a portion of the income is guaranteed over time. "You're trying to continue to have a diversified asset allocation strategy and within that, trying to introduce either a minimum guaranteed benefit or to have a portion of that fund invested in a vehicle that provides guaranteed income," says Suess.

Prudential now offers a series of target-date funds that include a retirement income guarantee that starts automatically protecting against volatility 10 years before the fund's target date. "It allows the individual to take lifetime income on a guaranteed basis from the fund, while keeping it as a target-date fund," explains Mark Foley, vice president, institutional income innovations group, with Prudential. "It continues to remain invested in the market, but they [investors] have a promise from Prudential that if they take withdrawals and those withdrawals exhaust the target-date fund, Prudential will then pay them a set amount of income for the rest of their life."

Foley believes that the guarantee enables portfolio managers to structure their portfolios in a way that they might get "potentially greater investment returns than you normally would with a target-date fund where you're trying to provide that downside protection strictly through asset allocation."

Guarantee detractors

Not everyone agrees that guarantees are a viable way for target-date funds to reduce volatility. The guarantees come at a financial cost to the investor, not to mention the communication costs associated with explaining them to employees.

"These other mechanisms do tend to complicate this issue tremendously," says Foley. "While it's possible that some of these solutions may have some investment merit, I think more attention needs to be paid to the cost of the solutions themselves, and then the cost in terms of making sure people understand what's guaranteed and what isn't, when things are guaranteed, and so forth."

But the financial cost could be worth it for some investors, particularly risk-averse ones. "If you think of a working career of 30-plus years, that [insurance or protection] might only be in the last 10 years prior to retirement, so they're only incurring that expense in the last five-to-10 years," says Nelson. "The typical cost for those types of products is in the 90-basis-points range."

Managing volatility

If there's one thing to be learned from 2008, it's that diversification among numerous risky assets can fail as a risk-management strategy, notes Mark Ruloff, director, asset allocation, with Towers Watson. "A better way to address risk is first by deciding how many of your assets should be in risk-reducing or liability-hedging assets and how many should be in risky assets," he says.

Ruloff sees an improvement among target-date funds in what they're using as their risk-reducing assets. "We're seeing a movement away from stable value as a low-risk investment and movement toward annuities and TIPS (Treasury inflation protected securities) as the low-risk investment," he says.

AllianceBernstein, meanwhile, has added a volatility management component to its target-date funds. The approach seeks to balance risk and return, placing primary emphasis on controlling risk. The company allocates up to 20% of its existing Retirement Strategies target-date funds into the new volatility management component, with the allocation varying by vintage.

The volatility management component will invest in a mix of equities and real estate investment trusts in normal markets but will have the ability to "de-risk" into bonds and cash when it's appropriate to reduce overall portfolio risk.

Fidelity, meanwhile, has maintained its focus on risk and return combined. "You can't focus on only one dimension," says Jonathan Shelon, manager of the Freedom Funds, Fidelity's target-date fund series. "You need to produce strong risk-adjusted performance sufficient to achieve retirement goals."

One of the ways Fidelity is doing that is through its risk allocation process, which gradually reduces the risk exposure to different asset classes over time.

"We don't just have the traditional stock/bond/cash mix, we also have extended categories like emerging markets, high yield, commodities and TIPS," says Shelon. "We've been spending a lot of time making sure that we're really well-diversified in all of the broad, as well as extended, categories."

Asset growth in target-date funds continues to remain strong so the "management of these products is becoming more sophisticated," says Suess. "[Managers are] adding investments to these products that are similar to what you might see in some of the larger defined benefit plans. For example, you're seeing greater emphasis on emerging market equities, some exposure to international bonds, increased exposure to real-asset-type funds, commodities, TIPS."

No more mandates!

Despite their disagreements over volatility and asset mix, providers are unanimous about at least one thing: They don't want more regulation. Mandating, for example, that a fund cannot have more than, say, 30% of its assets in equities, is wrong, they say.

"I think that's up to the plan sponsor and their consultant to pick the right model that fits their particular base," says Sturiale.

"I don't think those mandates would necessarily add any value to the target-date fund concept," says Ameriks. "There are different plan sponsors with very stringent fiduciary obligations to their participants to choose plan options that are in their best interests. Different plan sponsors are going to feel that higher or lower equity allocation, or including or excluding a certain asset class, is a prudent approach for their plan participants. That regulatory environment is just about as stringent as it gets."

But Gerald Wernette, a principal and director of retirement plan services with Rehmann, believes the target-date fund industry needs, at the very least, a common set of standards.

"The SEC and Congress have to get their act together in terms of having some standards these target-date funds are going to have to adhere to," he says. Providers should "have to do a better job clarifying your expenses, clarifying your risk profile, clarifying your investment objectives. If you're going to call yourself a 2040 fund, here's what that's going to mean when someone hits age 65 - this is the range you have to fit within. We're not there yet, but people are paying more attention to this stuff," he says.

Davis is the managing editor of Employee Benefit News, EBA's sister publication.