Time to Reevaluate Target-Date Funds

This article was originally published by Financial Planning magazine on Saturday, Aug. 1, 2009.

By Katherine Reynolds Lewis

When target-date funds (TDFs) were first introduced in the early 1990s, many considered them the best financial innovation in decades. They would incorporate best behaviors in asset allocation and rebalancing, and help individuals make age-appropriate investments. The funds really took off in 2006 when they became qualified default investment alternatives (QDIAs) for 401(k)s. Today, TDFs hold more than $180 billion in assets.

But when the financial markets collapsed in 2008, TDFs got hit—hard. Employees who were about to retire lost 25% of their portfolio, on average.

As the government takes a second look at the financial world, it is evaluating whether these funds protect investors'—your clients, whether they are employers or employees—best interests. Their findings will help shape the financial reform debate, as they cover who bears fiduciary responsibility, what is accurate nomenclature and what is an appropriate level of risk for a QDIA.

The SEC and the Department of Labor's joint hearing on June 18 was the first step toward new requirements for TDFs. Officials heard from nine panels of more than 35 witnesses who recommended enhanced disclosure, standardized naming of TDFs and even new rules for fund managers.

"We must focus on how best to address TDF issues in a way that benefits the investors who have entrusted these funds with $182 billion," SEC Chairman Mary Schapiro said in a speech after the hearing. The SEC will consider improvements in disclosure and will look closely at "whether the use of a particular target date in a fund's name is materially deceptive or misleading and should be prohibited."


INCONSISTENT GLIDEPATHS

TDFs contain a mix of stocks, bonds and other assets, and typically contain the expected date of retirement in their names, such as the Fidelity Freedom 2020 Fund. The allocation is set to become more conservative as the target date nears, according to a designated "glidepath." Financial planners who advise employers on retirement plans can choose from a wide variety of TDFs.

It has come to light, though, that these funds may share little beyond the date in their name. The equity allocations of TDFs with 2010 in their names, for instance, range from 21% to 79% of assets. For 2040 funds, the equity allocation ranges from 67% to 100%. "This dispersion of equity allocation in TDFs with the same target dates is surprising to many, especially to retail investors who rely on them precisely for their simplicity and ease of use," Schapiro said.

Several experts acknowledged this problem, but did not advocate any change in nomenclature of the investment process. Owing to their status as a QDIA, TDFs are likely to attract unsophisticated investors who don't actively manage their portfolios. Such investors are unlikely to understand complex fund disclosures—if they even bother to read them, observed Pension Advisors President David Krasnow.

A March survey of workers presented with TDF marketing materials found that 70% perceived they were being promised something and more than 60% believed such an investment guaranteed they'd be able to retire on the target date, said Jodi DiCenzo of Behavioral Research Associates, who also testified at the hearing. "American workers are investing in false hope," she added.

INSIDERS' POINT OF VIEW

Representatives of the mutual fund industry recommended that any confusion over the funds be addressed through education and enhanced disclosure—not new rules. They also sought to safeguard their freedom to choose the downward slope of the glidepath as retirement nears. "We strongly oppose any effort to regulate the glidepath or any investment design," said John Ameriks of Vanguard Group.

A JPMorgan analysis comparing the performance of its 2010 fund's glidepath to a money market fund found that, over the past 20 years, the TDF would have wound up with double the assets of the money market fund—even taking into account the 2008 losses, according to Ann Lester, senior portfolio manager for JPMorgan Asset Management.

But managers of TDFs run by Fidelity Investments, Vanguard Group, T. Rowe Price, Barclays Global Investors and others were still accused of insufficiently decreasing TDFs' allocation to equities after the retirement date. One of the controversies was whether a target-date fund should be managing funds to retirement—the date in the fund's name—or through retirement, with an asset allocation that takes longevity into account. Enforcing that distinction might require that funds be named and described differently than they are today.

Josh Cohen, a senior consultant for Russell Investments, wants to stipulate a flat glidepath after the retirement date, when the client is most at risk. "At that point, he has the longest time to live and thus the greatest amount of time for which he needs to fund retirement income," Cohen testified.

David Certner, legislative counsel for AARP, cited the long-believed assumption that risk aversion grows with age to support target-date investing. "Individuals prefer security over risk-related gains they could have by overwhelming numbers. They value security much more than potential upside returns." Jack VanDerhei, research director of the Employee Benefit Research Institute, also defended the strategy. TDFs move individuals from an all-or-nothing approach to equity investing into a more balanced approach, he said.

Michael Drew, a professor at Griffith Business School, called for a shift from the age-based design to a risk-based one, like that employed for life-cycle funds. Richard Michaud, president of New Frontier Advisors, agreed. "Age-based risk tolerance is a myth," said Michaud, who noted that investor surveys show risk tolerance changes very little with age. Individual circumstances—the level of wealth, income, family expenses and obligations—have much more to do with risk tolerance.

THE FIDUCIARY ELEMENT

It's also a conflict of interest for portfolio managers to invest exclusively in their own companies' funds, as 70% of TDFs do, said Jessica R. Flores, managing partner at consulting firm Fiduciary Compliance Center. This is one reason Mark Wayne, of the National Association of Independent Retirement Plan Advisors (NAIRPA), believes that the asset managers who design the glidepaths should be held to a fiduciary standard. Wayne suggested that fund companies use an independent third party to design the glidepath and ensure that buy-sell decisions are in investors' interest. Certner thinks the DOL should develop a monitoring tool to help fiduciaries evaluate TDFs with regard to asset classes, allocation, number and quality of underlying funds, glidepaths, costs and fees. This, of course, is exactly what asset managers oppose.

Randall McGathey, principal at RM Consulting, offered this idea: clearly differentiating between retirement-date and lifetime funds. The fund companies should sort TDFs into those that reach their lowest risk point at or before the target date and those that continue to change the asset allocation after the target, he suggests. JPMorgan's Lester agreed. "As a fiduciary, I understand how participants will behave as savers up to the point of retirement, but I can't predict how they will behave after retirement," she said. "Understanding the outcome you're trying to achieve, and then allowing plan sponsors or advisors to choose the fund that best matches their plan's needs, is critical."

It's unclear what the future holds for target-date funds. There's no doubt, though, that the hearings were the first round of a regulatory tug-of-war over financial services reform.