There's no denying that target-date funds are easy to understand and wildly popular with 401(k) plan participants, especially among new and inexperienced investors. But their performance has fallen considerably short in a still-fragile economy, as leading fund managers have pursued misguided strategies.
These developments come at a time when retirement savings clearly need to be maximized. So, the question becomes: Are participants better off switching to another fund that could bring better returns or should the TDF model be redesigned to better address stock market volatility?
Kent Smetters, a professor at the University of Pennsylvania's Wharton School, believes TDFs oversimplify to a point where "they can potentially be a bit dangerous." One such criticism is that these funds typically buy into the myth that a long time horizon alone should determine investment allocation.
While it's appropriate for younger people to have more exposure to equities, in large part because they have a lot of working years ahead of them, he says "they still have a pretty aggressive equity allocation when people approach retirement, and that's why some of these things blew up in the 2010 target-date funds."
But Ted Benna, known as the "father of 401(k)," feels TDFs have received a bad rap for heavy equity ownership during the economic downturn, explaining, "you are going to get hammered whether you are at target maturity or got hands-on advice." He says it's pointless for a 30-year-old to worry about a 50% drop in the stock market - that's the time to take any lumps - because the investment mix is age appropriate.
TDFs are now the leading default investment option for auto-enrolled retirement plans. Simplicity makes them appealing to the lion's share of defined contribution plan participants who'd rather not think too deeply about how to grow their nest egg. These funds are comprised of a premixed portfolio whose asset allocation strategy becomes more conservative as plan participants age, known as the "glide path."
TDF assets swelled to nearly $400 billion last year from $15 billion in 2002 and are expected to reach $2 trillion by 2020, according to a number of leading industry sources that include BrightScope, Morningstar and Financial Research Corporation. But performance was anemic in 2011, dipping 0.4% on average, relative to a 2% rise in S&P 500 returns and a nearly 8% gain in the Barclays Capital Aggregate Bond Index reported by Morningstar.
"Competition for pure performance distorted the objective of target-date funds," explains Joseph C. Nagengast, a principal at Target Date Analytics LLC in Marina del Rey, Calif., creator of the BrightScope On Target Indexes. "They were always meant to have returns and risk commensurate with the distance to the target date."
Nagengast believes account balances overwhelmingly are driven by a plan participant's contribution rate, not the return rate, noting that "looking to the returns to make up for a poor contribution rate is a fool's errand."
Many investors assume they're going to be protected in the final decade prior to the target date being reached and are deeply disappointed when there's a different outcome, according to Robert Pozen, senior lecturer of business administration at the Harvard Business School and a senior research fellow at the Brookings Institution.
"They all know that in the last 10 years the stock component is going down," he says. "But what they don't know is that there are huge differences among fund complexes as to how far down that equity component is going, which leads to big dispersions and results." The chief culprit is a wide variation in the equity portion that fund managers hold as the retirement age of their investors draws near.
Also, while it's safe to assume that some plan participants will live for a long time, he says others may need to liquidate most of their portfolio and live on those funds. Thus, one size does not fit all investors when their retirement needs and time horizons for investing differ so significantly.
Smetters' research suggests that sometimes TDFs "are so misallocated that it would actually be better to have defaulted people into very low-risk vehicles that invest just in Treasury inflation-protected securities."
A movement to determine best practices certainly should help improve the state of TDFs. There are 33 Morningstar TDF indices to gauge the performance of conservative, moderate and aggressive approaches. Two of the most noteworthy efforts include "Using a Target Date Benchmark" and "Selecting a Target Date Benchmark," which suggests that "from a qualitative standpoint, an appropriate target maturity benchmark should have a similar glide path philosophy, asset class set and methodology for determining the detailed intra-stock and intra-bond allocations."
However, a recent General Accounting Office report noted that significant variations in a number of critical areas that include objectives, asset allocation, investment strategy and underlying funds may render a particular TDF benchmark useless.
While custom composite benchmarks were cited as a means of measuring whether a fund outperforms the general market, the GAO cautioned that "they lack the ability to evaluate a TDF's glide path strategy or investment objectives" and that the bottom line is that "there is no universally accepted benchmark that can be used to evaluate all TDFs."
Mike Hartnett, a GAO senior analyst, says that while an agreed-upon benchmark for a midcap or large cap fund might be useful year to year, performance may vary.
"The problem with the TDF benchmark is that if you have a streak of years where the market is doing very well, your aggressive, high equity target-date fund is going to be doing fairly well compared to a more conservative one," he observes.
"But, depending on what kind of a TDF you really want as a plan sponsor or participant, that can be very misleading if your interest is conversely in capital preservation as you approach retirement. Another TDF may be more appropriate - one that is less exposed to the stock market, for example."
One alternative to benchmarks mentioned in the report involves "forward-looking metrics that evaluate the risk/reward characteristics and the range of possible long-term performance outcomes of the TDFs - such as retirement income replacement rates and longevity risk (e.g., the risk that a participant runs out of money before death)."
Emergence of custom designs
As scrutiny of cookie-cutter approaches to TDFs mounts, the market is expected to make adjustments. Damon Winter, vice president of the Majestic Eagle Agency, Inc., in Clackamas, Ore., and a member of the Million Dollar Round Table association of financial professionals, believes plan sponsors will embrace custom designs and tactically managed strategies with better asset allocation mixes made over time to reduce risks associated with market downturns.
This could involve a more conservative, moderate and aggressive approach to individual target dates and is superior to what he calls the buy-and-hope model (a pithy reworking of the buy-and-hold strategy that he says hasn't worked well since the 1990s).
Custom target-date funds are proliferating at the expense of their off-the-shelf counterparts, in part because plan sponsors want to have greater control over what's in a fund and have access to a wider array of investments to put in them.
Indeed, about 20% to 25% of plan sponsors with target-date funds are likely to switch to customized approaches by 2015, up from roughly 13% today, research and consulting firm Celent projected in a recent report.
Customized approaches allow plan sponsors to choose multiple managers and replace them as necessary. They also give access to asset classes such as commodities, direct real estate, and hedge fund and private equity investments that retail funds may be prohibited from owning.
They also can charge lower fees to plan participants because of institutional pricing and give the ability to customize the so-called "glide path" for changing over to more conservative investments, depending on the demographics of a particular workforce.
But they're usually only available to larger plan sponsors because of the time and cost involved in setting them up and running them. Sponsors also assume additional fiduciary responsibility when they choose managers and tailor glide paths.
"As markets continue to demonstrate volatility, it's likely, though not guaranteed, that sponsors will look to these custom designs," says Alexander Camargo, the author of the Celent report.
Benna is a big fan of what he calls "TDFs done right." A few years ago, he moved a $50 million retirement plan to this model and gave participants the option of running the plan on their own through a mutual fund window. More than 90% of those plan participants have stayed in those funds, which are indexed to better withstand market fluctuations and high expectations associated with annual performance vis-Ã -vis industry benchmarks. It's also worth noting that the plan overhaul reduced total plan cost to just 16 basis points from 75.
TDFs "aren't designed to be just one of another in a menu of 25 funds," Benna cautions. "You get stupid results when participants continue to pick individual funds and 10% or so of a couple of target maturity funds. They should be in a plan where these are the only funds there."
His point is that TDFs provide adequate diversification in a single fund. But that's not reflected among most TDF investors. For example, slightly more than one-quarter of 401(k) participants with Fidelity Investments parked all of their assets in TDFs at the end of last year, whereas it used to be just 21.4% in 2010 and 17.4% in 2009.
One bright spot is that better disclosure about glide paths means "presumably people will know whether their fund is going down to 30% equity or 10% equity," Pozen observes. But he says there also needs to be "better disclosure that there is no guarantee against losses in the last 10 years."
Plan sponsors should embrace fund companies that are moving back to the fundamentals involving growth in the early years and preservation in the latter years as part of a prudent, safe and proven investment policy, according to Nagengast.
Five-year returns were poor among the three leading TDF players (Fidelity, Vanguard and T. Rowe Price) when measured against BrightScope On Target Indexes because of what he describes as a failure to protect investors in down times - with too much equity at the target date (see sidebar, left).
But the real issue is how these concepts are explained to plan participants. Winter laments the fact that most plan participants don't bother to learn about their investment portfolio when so many sponsors provide excellent educational materials.
He says this phenomenon feeds a mentality advanced by the Pension Protection Act - that plan participants can simply check a box for automatic enrollment without fully understanding their options. Winter has seen many eyes glaze over during employee meetings. "They are intimidated and uncomfortable even having these conversations."
Bruce Shutan, a former EBN managing editor, is a freelance writer based in Los Angeles. Additional reporting by Nelson Wang, a writer for On Wall Street, a SourceMedia publication.
3 reasons to think twice about TDFs
1. Some funds take too much risk too late in the game.
Imagine you were planning to retire in 2010, and had invested in a target date fund. On aver-age, target-date funds set to mature that year declined 37% between the market peak in Octo-ber 2007 and March 2009, according to Morningstar. Why? Too much exposure to stocks. Yet, the percentage of stocks that target-date funds hold at their target date rose to an average of 43% in 2010 from 40% in 2007, according to Brightscope.
2. TDF risks aren't clearly disclosed.
There's a debate over whether a target-date fund should hit its most conservative allocation â€” known as the "landing date" â€” the year an investor retires, or provide for the rest of his life."To" funds â€” think a target-date fund should hit the target date and landing date the same year. Thus, an employee who retires in 2040 at age 65, just as his TDF cuts the per -centage of stock it owns to its lowest level. About 40% of funds followed this philosophy in 2010, Brightscope found.The other 60%, known "through" funds, think they should provide for retirees for the rest of their lives. Since people run the risk of outliving their money, this camp continues to take some risk after the target date so his money has a chance to grow. It's critical to under -stand if you have a "to" or "through" fund to gauge risk. However, it's tough to figure out a fund's philosophy by looking at the fund documents. Even the gurus at the Morn -ingstar, which ranks mutual funds, have complained that the data is hard to find.
3. Fund managers have conflicts of in -terest and mediocre regulatory safe-guards.
Investors have to pay more for actively-managed stock funds than bond funds (or index funds, which simply mimic the major indexes such as the S&P 500). That gives the managers an incentive to stuff the target-date fund with the more profit -able (and riskier) funds.
Source: AOL, Daily Finance
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