An Argument for 'To-Retirement' TDFs

Ron Surz, president of Target Date Solutions, has developed something of a reputation as an outspoken critic of target-date funds (TDFs) in the wake of the 2008 financial crisis. His firm is a division of PPCA Inc., specializing in target-date products that incorporate elements of capital preservation and take a more conservative approach than many target-date funds currently included in defined contribution (DC) plan lineups.

It is a challenging balance to strike, Surz tells PLANADVISER, between helping participants limit investment risk while also addressing longevity concerns. And it is not a challenge that will disappear any time soon, he notes, with more than $600 billion already tied up in target-date funds and accelerating growth expected as the products are included in more plans as qualified default investment alternatives (QDIAs).

In fact, Surz’s firm believes target-date fund assets could top $4 trillion by 2020 and represent more than half of all assets in 401(k) plans—figures close to predictions published by industry research groups including Morningstar and Cerulli Associates, among others.

Target Date Solutions calls its TDF strategy the “Safe Landing Glide Path.” Funds that adopt this glide path, Surz explains, are designed to fall below a 10% equity allocation at the retirement date—substantially lower than many funds on the market. They are also designed as “a to-retirement” vehicle that focuses solely on asset accumulation and operates under the assumption that a participant will likely withdraw his account balance upon retirement.

Surz says this approach is preferable for both individual investors and for wider plan outcomes when compared with the other broad category of target-date funds—“through-retirement” funds—which are often designed to retain investments for 25 or 30 years beyond retirement. Surz says this need to achieve growth so far beyond the retirement date typically translates to between 30% and 70% equity exposure at the target date, depending on the specific fund and provider. “And we all know what happened to target-dates with 70% equity exposure in 2008,” he says.

Surz is quick to add that higher levels of equity exposure may be necessary for workers with savings shortfalls in the approach to and early years of retirement. The problem, he argues, is that investors do not seem to understand that different TDFs with the same target date can have substantially different glide paths and substantially different levels of risk, so it is not hard to imagine how a participant could buy the “wrong TDF,” depending on his particular needs.

It is also not hard to imagine the shock many retirement investors must have felt in late 2008, he says, as many funds with a 2010 target date fell some 25% to 35%, despite the promise of limiting risk in the approach to retirement.

It adds another level of complexity to the discussion when considering that even target-date funds with similarly shaped glide paths can take more aggressive and conservative approaches, affecting the funds’ risk and return profile and requiring further diligence from investors and plan sponsors. It is an issue currently being reviewed by the Securities and Exchange Commission (see "SEC Reconsiders TDF Glide Path Illustrations").

Like Surz, the SEC feels that many investors have misconceptions about target-date fund products, some of which may be cleared up by mandating glide path illustrations. For instance, investors often believe their fund’s target date is the point at which the asset allocation stops changing. Others believe the target date is the point at which the fund is at its most conservative allocation, the SEC says, but neither of these facts is necessarily true, depending on whether the fund is designed as a “to” or “through” fund.

The bifurcation of actively managed target-date funds and those with an index-based approach also challenges investors, the SEC says, and a host of hybrid products have come to market that may be causing confusion about what fee levels are fair and appropriate for target-date strategies (see "Can You Really Set It and Forget It?").

Surz says conservatively managed “to” funds are preferable because they seek to reduce exposures to risky assets well in advance of retirement, so investors can better plan for their post-retirement well-being. The “to” approach also decouples the accumulation phase from the distribution phase to help retirees make better decisions about their portfolios in the years after retirement, Surz says. Even in cases where a larger equity allocation is desired post-retirement, it will be preferable, he says, for investors to approach this investing phase thoughtfully, rather than relying on poorly understood target-date funds to carry them forward.

He likens the more conservative approach of to-retirement funds to the liability-driven investing (LDI) philosophies commonly adopted by the largest institutional investors—who tend to be more concerned with meeting predetermined goals or needs and addressing specific risks rather than just maximizing potential performance (see "Is LDI Feasible for DC Participants?").

Surz points to his firm’s Safe Landing Glide Path as a better way to direct target-date investments. When the target date is distant, he explains, a world portfolio (the “risky asset”) is used to optimize return per unit of risk, encompassing a globally defined mix of the major asset classes, including stocks, bonds, real estate and commodities. As the target date nears, account balances are increasingly placed in a safe “reserve asset” that is composed of short-term inflation-indexed Treasury securities—TIPS—and 90-day Treasury bills.

Unlike glide paths that shift only according to the passage of time, Surz says this approach can also be used to factor in market performance considerations. For instance, the strategy dictates that portfolio managers first estimate the worst-case potential loss on the risky asset from today’s date to the target date and then allocate to reserves to compensate for that loss. So if a worst-case “risky loss” actually occurs, the fairly safe return on reserves should make up for that loss, Surz says.

As a result, the safe landing strategy is almost entirely in reserves at the target date, Surz says, an essential feature ignored in most target-date funds. Put another way, substantial losses on risky assets can happen very quickly, he says, so those nearing retirement are in jeopardy unless they hold very little in risky assets.