February 23, 2009
TALKING ABOUT TARGET DATE FUNDS ON THE INSIDE VIEW PODCAST
Target date funds have become popular in recent years because they offer one-stop shopping for managing the asset allocation challenge. If you're retiring in, say, 2030, you can buy a target date fund to oversee your asset allocation with your retirement date in mind.
But as today's episode of The Inside View reminds, not all target date funds are created equal and so there's design risk to consider when choosing among these products. The critical variable in target date funds is the underlying index that governs the fund's strategy. As such, the design and management of the benchmark determines much of the success, or failure, for any given target date fund.
Today's guest, veteran investment consultant Ron Surz, knows a thing or two about how to build and analyze investment indices. His firm PPCA Inc. designs and sells a sophisticated suite of software tools for analyzing portfolios and investment indices. Ron is also president of Target Date Analytics, a consulting and research firm that designs target date fund indices, which are used by the SMART Funds Target Date Series.
As Ron explains in today's episode of The Inside View, index design is fate for target date funds. Unfortunately, not every target date fund is looking at a rosy future. One problem, he says, is a lack of a sound methodology for some target date benchmarks…
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Posted by jp at February 23, 2009 11:06 AM
Target funds have been a disaster for participants in 2008. Many participants who would have had positive returns in 2008 in their old default option (stable value or money market) were strongly encouraged or even forced out by their employers into target funds with heavy equity exposures giving them losses of -10, -20, or even -30% for 2008. Anecdotal reports are that the higher losses now inflicted on the most vulnerable of 401k investors (those in defaulted options) have had a negative effect on participation. This was the opposite effect of the stated intent of the Qualified Default Investment Alternative (QDIA) decision by the Department of Labor. (DOL)
The Target Date marketing craze started in anticipation of a change in DOL rules that would allow or even encourage some “equity” in the default option based on very long term expectations in the equity market. The October 2007 QDIA decision by the DOL opened the floodgate for Target Date funds as the major target date funds aggressively pushed plans to adopt them by January 2008, a little over a 2 month window. Many plans adopted these new options and as their default option quickly without significant due diligence. Did plans got caught up in the buzz and actually harm many of their participants? It can be argued that many Plans did not dig deep into what the DOL QDIA really said; they only looked at the spin provided by the sales people at the target funds. The DOL clearly stated plans in this case have a duty to know the risk tolerances of their participants and make their own independent judgment as a fiduciary if it was prudent to shift them from a 0% to in some cases 70% equity exposure overnight. Plans also should have noticed letters to the DOL from many groups included the Profit Sharing / 401(k) Council of America (PSCA), ERISA Industry Committee the AFL-CIO, and the Pension Rights Center who fought to keep a capital-preservation option as a QDIA, that keeping their old default option could be prudent if it fit its participants.
Volatility can drive down Contribution Rates
There were many warnings prior to the 2008 stock crash that the risk levels for many of these products was too high for most participants.
Zvie Bodie Commenting on the QDIA rush to target funds said “We found that people with relatively high risk aversion and a high exposure to market risk through their human capital would experience a substantial gain in welfare from being offered a safe target-date fund instead of a risky one.”
Comprehensive studies by the Compass Institute a think tank that focuses on investment strategies conclude that formulaic asset allocation approaches to investing – such as those employed in lifecycle, target date and balanced funds – unequivocally fail to provide participants with adequate savings for retirement, citing exposure to just one down year in the market as one of the pitfalls.
The Department of Labor (DOL), which fleshed out the PPA through regulations, was warned of this potential effect by its own peer reviewer, Nellie Liang of the Federal Reserve. “In particular, the outcomes should be evaluated based not only on expected values from retirement balances but also utility since workers are likely to be risk-averse. For lower income workers with few other financial assets, the additional volatility in pension balances might be especially costly. For lower income workers, it could be the case that the additional expected income from the lifecycle fund may only come with an unacceptable additional amount of risk. The assumed equity premium may be too high.” One down year in an equity-heavy investment option can lead participants to lessen or halt contributions, which are the real key to accumulation, according to Putnam. Its recent study suggests that over 90% of accumulation in retirement plans is attributable to contributions, while less than 10% is attributable to investment returns. Putnam’s study shows that a one percentage point increase in contribution levels has twice the effect of moving from a conservative portfolio to a growth portfolio over a period of 16 years. Participants who fall under the default option in many cases are lower income workers with lower risk tolerances, something many plans looked over as they rushed to move to target funds.
The potential for less contribution by many participants is something plans should consider in picking a default option or even the type of target date fund. Information was out there but perhaps buried by the Target Date marketing avalanche.
--Chris Tobe, CFA, CAIA, consultant to Breidenbach Capital Consulting
Posted by: Chris Tobe at April 3, 2009 6:46 PM