The Great TDF Debate: Prudence vs. Performance

Some weeks ago, PLANADVISER covered the publication of a new ERISApedia.com report exploring the correlation of market share and quality among target-date funds (TDFs).

The report suggests that there exists a “fair amount of correlation between market share and the quality of a target-date fund vis-à-vis its peers in the target-date category as measured by an industry-recognized fund scorecard.” In this case, ERISApedia.com analysts utilized Fi360’s Fiduciary Scores to conduct their research.

According to the study, the correlation between market share and third-party rated quality is “especially strong” in the bottom 100 target-date families by market share. In other words, none of the smallest target-date funds have favorable Fi360 Fiduciary Scores. Important to note, the research authors emphasize that, in the practical operation of retirement plans, a simple assessment of market share alone obviously cannot be used as a substitute for normal TDF due diligence. Still, they conclude, it can be instructive to analyze the market traction of a given TDF product.

Responding to this reporting, Ron Surz, a regular reader and the president of Target Date Solutions and GlidePath Wealth Management, submitted some timely analysis of his own, emphasizing the need for caution when talking about TDF “quality” in isolation of a deeper discussion of risk tolerance and performance expectations.

As Surz has discussed previously with PLANADVISER, there is often a heavy weight placed on one, three and five-year performance, including in objectively generated TDF ratings. This makes sense to some extent, because risk-adjusted performance is very important to participant outcomes. But, Surz says, the “risk adjusted performance” element is often overlooked, and analysts are not necessarily concerning themselves sufficiently with how the most popular TDFs may perform in periods of severe market stress. Surz even says that many analysts “reward TDF imprudence.”

An Alternative View

Surz has generated his own “TDF Prudence Score” system that, generally speaking, favors a very different set of TDFs versus funds rated highest by a Morningstar or Fi360.

What is the reason for this? Surz says the biggest TDFs have become the biggest in part because they have taken more risk relative to their peers, and they have been rewarded for doing so by what has turned out to be the longest running bull market in U.S. history. But matters could have easily turned out differently, and markets are sure to sour one day in the future. Thus, in Surz’s view, TDF investors are not adequately being informed about the risk they carry in what many falsely believe to be safe or even guaranteed investments. Prudent TDFs, in his view, soberly balance the need for return with the need to protect retirement investors’ hard-earned dollars, especially during the critical time period that immediately precedes and follows the retirement date. 

Surz offers the following a summary of what he thinks fiduciaries should know about target date funds:

1. Beware the performance trap. Imprudent concentration in U.S. stocks has won the performance horserace in the past decade.
2. Protect against lawsuits, looking beyond costs. Fiduciaries want protection from lawsuits, so they choose popular TDFs, but they may be unsafe for beneficiaries. Surveys of beneficiaries reveal that they want a lot less risk near retirement than they get in popular TDFs.
3. Address decumulation. More plan sponsors are encouraging retirees to stay in the 401(k), probably even more in union plans.
4. Evaluate performance. There is no standard, but there should be.
5. Address demographics: The only demographic that defaulted participants have in common is financial disengagement.
6. Protect beneficiaries. Consider the trade-off between growth and preservation, especially near retirement. There are different schools of thought.
7. Choose between “To” or “Through.” Absent a discussion of many other important factors, this is a distinction without a meaningful difference.
8. Diversify. This remains the only free lunch in investing.
9. Manage risk. Dr. William F. Sharpe won a Nobel Prize for the Capital Asset Pricing Model that controls risk by blending a “risk-free” asset with the global market of risky assets. Ibbotson calls this the “Separation Principal” because it dictates just two assets: risk-free and the world market.  

More Tips on How to Carefully Evaluate Target-Date Funds

Surz is far from the only analysts asking big questions about the TDF marketplace and how to best serve retirement plan participants, who, given their general lack of investment expertise, rely heavily on both their fiduciary plan sponsors and on product manufacturers to look out for their best interest. Given their widespread use as the default investment in many plans, TDFs are projected to hold more than half of all retirement plan assets by 2025.

Brendan McCarthy, head of defined contribution investment only (DCIO) national sales at Nuveen, tells PLANADVISER it is more critical than ever that retirement plan advisers and sponsors carefully evaluate TDFs in their lineup.

“We are seeing a huge focus on the QDIA [qualified default investment alternative], with advisers employing the three R’s,” McCarthy says. “The first is to reevaluate the TDF. The second is to replace it if it is found to not be appropriate, and the third is reenrollment, which is a great way to get a plan back on track in terms of where participant allocations should be.”

In addition, as exposed following the Great Recession of 2008, “there is an alarming amount of variation in risk composition from one target-date fund manager to the next,” Newport Group writes in a white paper, titled, “A Prudent Approach to Evaluating Target Date Funds.” The firm believes that prudent selection of a target-date manager must consider many factors beyond the basic intention of the strategy.

“Some managers will choose the conservative path and dial down equity exposure early,” the firm says. “Other managers will consider the risk of underfunding and outliving retirement assets and will maintain an aggressive posture in their portfolios for years after retirement.”

Besides the quantitative analysis of performance, there are qualitative factors to consider, according to Newport Group, most important of which is the diversification of the underlying holdings in the TDF. “Is there sufficient diversification across asset classes and sub asset classes?” Newport Group queries. “Are nontraditional and lower correlated asset classes such as REITs [real estate investment trusts], emerging markets, global bonds and high yield bonds included?”