When One Size Fits Almost No One

The “set it and forget it” legacy of target-date funds is fading fast, as advisers and fund managers grapple with the need to alert plan participants to the myriad shapes and sizes of target-date strategies. Target-date funds, also known as lifecycle funds, are designed to move money from riskier investments such as stocks to more conservative alternatives like bonds as investors approach a date close to their retirement.

In particular, questions have arisen over the time horizons and equity weightings of these funds: Should they be longer, to accommodate increasing retiree life spans, or shorter, if participants expect to do something different with their money at retirement? Should employers state categorically that target-date funds are not pension-like guarantees but actually bear market risk? Should plan materials specify that the suite of target-date funds their company offers may leave them with more stock exposure at retirement than another suite of funds with a similar name and target retirement year? Industry experts and government officials are considering all of these questions, with an eye toward keeping participants apprised of what is behind their target-date label and whether it will fit their retirement goals.

The fact is that target-date funds are hugely popular as well as widely misunderstood. No less than 7.3 million Americans held target-date funds in 2008, according to the Employee Benefit Research Institute’s database of 24 million 401(k)s and, yet, investor confusion is rampant.

A recent Janus Capital Group study found, nevertheless, that many participants do not understand what these funds are or how to use them properly. The study echoes previous findings that target-date fund holders show a propensity for overdiversifying (either by combining target-date funds of different dates or by combining target-date funds with other mutual funds). In fact, more than 80% of respondents believe that target-date funds need to be combined with others to achieve a diversified portfolio, and 70% of respondents believe that combining target-date funds with other funds in their 401(k) plan is the preferred way to generate retirement income. It also finds that participants tend to select target-date funds for the year they expect to leave the company instead of the year in which they intend to retire and, although a much smaller group, approximately two in 10 surveyed incorrectly believe that target-date funds provide pension-like guarantees.

Selection of a fund to invest in should be easy—simply match a participant’s retirement date with the year in a fund name. However, the discrepancies between allocations of same-named funds can make for confusion. Funds with the same so-called vintage year do not contain the same asset allocations and strategies for coping with participants’ longevity or retirement lifespan. One investigation by the U.S. Senate Special Committee on Aging recently found that the equity allocations of various 2010 target-date funds ranged from 24% to 68%. Therefore, names like the “2020” or “2040” fund notwithstanding, advisers and fund companies alike are helping plan sponsors to put the message across that no one fund flavor will suit everyone retiring in a given year.

“To” Versus “Through”

As noted above, there is a wide range of target-date approaches now in force, most of them with a strategy extending well beyond a plan participant’s retirement date to offer them a managed approach over a longer time period—often 20 years or more beyond their fund’s vintage date. The idea is to help participants preserve assets, though critics observe that fund companies also enjoy hanging on to significant revenue streams and fund fees over extended periods of time.

Observers note that the “to” target-date approaches that exist require participants to take matters into their own hands when they reach the end of their fund glide path, by investing balances in some different approach, like an annuity, to provide them with a regular revenue stream.

“The glide paths of ‘to’ funds are designed to end at the target date, requiring the plan participant to do something quite extraordinary—think and act,” observes Ron Surz, Co-Founder of Target Date Analytics in San Clemente, California. He reasons that few participants leave their savings with the plan when they terminate employment, and will need to rethink their strategy anyway. This may entail a move to an annuity or another low-risk strategy.

Jerome Clark, Portfolio Manager of the T. Rowe Price Retirement Fund portfolio in Baltimore, on the other hand, considers the “through” approach to be appropriately “paternalistic” at a time when participants are most in need of guidance. Moreover, things needn’t end when funds leave the employer plan. “With our product, you can always keep the same target-date strategy going with an IRA,” says Clark.

Movement Toward “To”?

In light of the turbulent market environment and the increased evaluation of target-date funds, the marketplace already is seeing a few changes. Before November of 2009, for example, investors in John Hancock’s original target-date funds landed at a 50% allocation to equities at retirement date. Following December 31st of the retirement year, each dated portfolio would merge into a retirement income fund, which had a 50% target allocation to equities, Hancock reports. Hancock’s retirement income fund had a 39% allocation to equities in December 2007, and 47% of assets in equities at year-end 2008.

“John Hancock historically had one of the most aggressive glide paths,” says Josh Charlson, a senior mutual fund analyst at Chicago-based Morningstar, referring to its target-date formula over a series of years. Last November, however, John Hancock extended its own glide path for 20 years and rolled down its final stock allocation to just 25% equities and 75% fixed income, instead of the 50%/50% glide path of earlier years. The change came just a few months after hearings where the Securities and Exchange Commission (SEC) and Department of Labor (DoL) officials heard testimony as to whether target-date funds should take workers “to” or “through” retirement.

“Some [companies] flat-line equity exposures at the target date; some might reach a landing point of 15% to 25% equity exposure or lower over a 10- to 20-year period, as with Hancock’s new strategy,” Charlson observes.

On the conservative end of the spectrum is Wells Fargo, with an equity allocation of some 26% at retirement in its 2010 fund, according to Morningstar, while T. Rowe Price’s 2010 strategy has a 60% stock allocation at retirement date. T. Rowe—widely known for a glide path spanning some 30 years and taking participants into their 90s—was hard at work last year meeting with plan sponsors and explaining that the company was committed to its glide path and saw no reason to adjust it to accommodate for a temporary market downturn, however severe.

Unfortunately, without some significant new communication efforts from plan sponsors and their service providers, most of these target-date dynamics are likely to be lost on a majority of plan participants.

What can be done? Officials at T. Rowe Price, whose Retirement 2010 approach was among the largest target-date fund losers in 2008 with a negative 26.71% return and one of the best performers last year with a 27.95% return, say that T. Rowe has become even more vigilant about the clarity and quality of educational materials it presents to participants.

“We really are emphasizing and want to make participants understand they will be near a 55% equity allocation at retirement,” says Clark.

T. Rowe is one of the giants of the target-fund universe along with Fidelity and Vanguard. These three firms made up 73% of target-date assets last December, according to Boston-based Financial Research Corporation.

Participants must be keenly aware that they are “in the market and exposed to market risk,” Clark says. In all of T. Rowe’s communications, from newsletters to e-mails to quarterly reports, the fact that target-date funds are not a “guaranteed” solution but are exposed to market fluctuation is “being dialed up a bit,” adds Carol Waddell, Director of Product Development with T. Rowe Price Retirement Plan Services.

Charlson also observes that, based on a new SEC filing Hancock issued in February, 2010, the company likely is preparing to issue a brand-new target-date series incorporating a still-more conservative glide path.

Practical Solutions

Eric Freedman, Managing Director of the Consulting Research Group at CAPTRUST Advisors—an independent investment advisory firm in Raleigh, North Carolina, with some 450 plan sponsor clients—agrees that the professional investor community needs to share responsibility with SEC and DoL officials dealing with the target-date issue. CAPTRUST offers a couple of rules of thumb for plan sponsors and advisers working with target-date funds:

• Know Your Customer: “A risk-based fund solution may be a better fit than a target-date fund for participants who can identify themselves as conservative investors,” says Freedman. For plan sponsors with older and, perhaps, more risk-averse participant populations, many target-date funds could prove too volatile for their average participant, he says. CAPTRUST suggests that plan ­sponsors be able to demonstrate the link between target-date funds and their plan population.
• Teach Target-Fund Basics: Employers would be wise to go over some basics with target-date participants, who often invest in a way that serves to undermine the target-date fund strategy. A recent CAPTRUST position paper entitled “Target-Date Funds: Buyer Be Aware,” explains that “Target-date funds [TDFs] are designed such that investors select (or are defaulted into) a vintage year based on their age. A vintage year is, for example, the Fidelity Freedom 2040 Fund or the JP Morgan Smart Retirement 2015 Fund.

 “Without question, certain TDF investors select vintage years based on their underlying allocations or even invest in multiple vintage years but, from a design standpoint, TDFs are structured so that any single age group will invest in the same vintage year,” according to CAPTRUST.

• Consider Glide Path Diversifiers: “In 2008 and 2009, correlations between asset classes were very high,” says Freedman. “It’s not just equities that can go bump in the night. When market contagion sets in, even market-grade fixed income can act like equities, requiring a higher degree of capital preservation.” Freedman emphasizes, “It is up to advisers to do the research to help delineate between strategies that are well-diversified and those that aren’t.”
• Investigate Flexible Glide Path Strategies: “Certain TDF providers have more investment flexibility than others and, as such, plan sponsors should take note of [that] varied latitude as designated by prospectus and mandate,” CAPTRUST advises. Manning & Napier Advisors, Inc., for instance, offers a glide path allowing a 25% to 40% “swing” in equity allocation depending on market conditions, according to Patrick Cunningham, a Managing Director with the Rochester, N.Y.-based investment management company. “As you get closer to retirement, the equity allocation range decreases to a bottom of 5% to 35%.”

Clearly, participants who got burned in the market downturn are looking for direction and new alternatives, be they target-date funds or other choices. “As Mark Twain would say, a cat doesn’t sit on a hot stove twice, and what we don’t want to see happen is investors becoming disillusioned with investing because certain investment products don’t meet their needs,” says Freedman.

In that very spirit, Morningstar is beginning to see a bit of a trend toward steeper glide paths where more risk accrues while investors are young, Charlson observes. Charles Schwab, for instance, recently added 11% more equity exposure to its 2040 strategy at a time when investors are in their 30s or younger, Charlson reports.

Obviously, “losses in 2008 have made some fund companies a little more cautious about taking on risk close to retirement age.”