Target-Dates Useful but Flawed, Witnesses Tell SEC and DoL

In opening remarks, DoL Deputy Secretary Seth Harris noted that recent concerns have been raised about variation in the glide paths of same-date target-date funds offered by different providers, and how this variation may result in plan participants and investors unknowingly placing their retirement assets at risk. He said the hearing will help the agencies determine whether regulatory or other guidance would be helpful to alleviate these concerns.

“While participants need to have pre-built asset allocations to assist them in reaching a secure retirement, target-date funds, as currently built, represent a flawed, though useful, way of achieving this objective,” asserted Donald Stone, president of Plan Sponsor Advisors, in his testimony.

Stone explained that target-date funds were designed to provide participants with a simple choice to achieve a diversified portfolio, but most target-date funds operate off of actuarial assumptions of participant life expectancy that he said lead to a too-high equity allocation at age 65.

The flaw, according to Stone, is that target-date funds are built as asset accumulation vehicles, not distribution vehicles, and there is no evidence to indicate that participants would stay in target-date funds throughout retirement. Nor do target-date funds take into consideration the impact of mandatory distributions at age 70 1/2.

Stone noted that participants are more likely to take relatively large distributions upon retirement, and a high equity exposure at retirement date enhances risk as participants no longer have the ability to continue to contribute to the plan to make up for potential losses. Their financial profile is radically changed from income generating to income consuming—something that target-date funds do not generally take into account, he argued.

Joseph C. Nagengast, of Target-date Analytics, also contended that the two biggest contributors to risk in target-date funds are the amount of equity in the fund, and the design of the glide path. “There is some theoretical rationale for employing a glide path throughout the accumulation phase. No credible rationale has ever been proffered for using a glide path in the distribution phase,” Nagengast commented.

He suggested that what drove the majority of target-date funds so far off course and caused the unacceptably large losses to 2010 funds in 2008 was fund managers attempting to use the key engine of target-date funds, the glide path, for purposes other than its primary function—which he said should be getting investors safely to their target date with their accumulated contributions, plus inflation, intact.

Nagengast said that, properly designed and managed, target-date funds can serve participants very well. He urged that the Senate do nothing that would stop the adoption of target-date funds in qualified retirement plans, but put forward some suggestions for improvement:

• The name of each fund must bear some relationship to the way the fund is managed, that is, its glide path. If a fund labeled 2010 is really targeted to “land” at 2040, it should be re-labeled as a 2040 fund.
• The glide path must be designed to provide for a predominance of asset preservation as the target nears and arrives.
• Prospectuses should be clear about the objectives of the funds – specifically, no circular definitions of fund objective should be allowed. Language describing the objective of a fund as dependent on its allocation should not be permitted. The objective is properly dependent on the fund’s allocation; not the other way around.

No Restrictions on Investments

In his testimony before the DoL and SEC on target-date funds, Chris Tobe, trustee, Kentucky Retirement Systems, contended the target-date funds make many flawed assumptions about employee turnover and behavior. In addition, he said many target-date fund asset allocation decisions are based on flawed assumptions on equity versus bond-like returns.

He noted that an April 2009 report from Hewitt says 36% of 401k assets are in stable value; however, the 2003 SEC decision to not allow stable value mutual funds kept them out of most target-date funds. He asserts that maybe now is the time to reintroduce stable value mutual funds. “While they are not immune from the recent market issues, they would have, in my opinion, held up as well or better than money market mutual funds over the period. They would provide great stability to target-date funds,” Tobe said.
Jeffrey S. Coons, Manning & Napier Advisors, Inc., stressed the importance of flexibility in managing the glide path and underlying investments of a target-date portfolio given the changing nature of investment risk as market environments change. He said his firm believes increased transparency, disclosure, and communication to plan fiduciaries and participants is a more appropriate response to the concerns raised regarding target-date fund performance than invoking investment-related restrictions on the glide path or underlying investments of target-date funds.

Coons said a flexible glide path that factors in time, withdrawal needs, and market conditions allows the manager to balance the conflicting goals of managing capital risk, inflation risk, and longevity risk. Manning & Napier has concerns about placing restrictions on asset allocations along the glide path as it could hamper target-date fund managers’ ability to pursue these long-term investment objectives.

Instead, Coons suggested, it is important for target-date fund managers to effectively communicate to both plan fiduciaries and participants the key assumptions they have made regarding investor time horizons and withdrawal needs when constructing their glide path. Managers should also explain how they intend to proactively adjust their allocations in a changing environment and provide both their experience and actual track record of making such proactive adjustments over a range of environments, as opposed to simply rebalancing within a fixed glide path.

“We believe improvements can be made on the industry’s disclosure of the investment approach taken with respect to selecting and monitoring underlying holdings, including more disclosure and education regarding the total number of holdings to better inform plan sponsors and participants as well as guard against investors paying active management fees for these vehicles that are over-diversified and under-disclosed. Likewise, disclosure to plan sponsors and participants regarding the fee structure of underlying investments in a fund-of-funds environment can help them guard against biases in allocation decisions related to fee differences among underlying funds,” Nagengast concluded.

Benchmarking Target-Date Funds

Addressing the problem of benchmarking target-date funds, Rod Bare, director, Asset Allocation Strategies, Morningstar, said target-date funds are difficult to benchmark in the traditional sense because of the glide path diversity in the marketplace that has developed to meet the needs of a wide range of investors.

Bare contended that fiduciaries and individual investors ultimately need tools with several attributes to help with this evalua­tion. They need benchmark indexes built to reflect the multi-asset-class and risk-shifting nature of target-date funds. Investors also need the ability to evaluate the asset-class and security-selection components separately to understand the quality of each piece, he said.

According to Bare, Morningstar expects that market forces will create these types of evaluation tools. The increased scrutiny provided by these tools could lead to target-date fund consolidation in the marketplace, and “investors will benefit handsomely from the subsequent increase in product quality and selection advice.”

With the industry opportunity that’s linked to such strong asset growth in target-date funds comes the responsibility to provide scrutiny and benchmarking guidance to the target-date market. “Expanded fund portfolio analysis and spe­cialized fund family metrics are industry developments that should emerge in the near-term for the benefit of individual investors, plan fiduciaries, and fund manufacturers.”

Bare noted that glide path differences make comparisons difficult, yet glide path diversity is a good thing, as it is universally accepted that investors have different risk capacities, tolerances, retirement goals, and financial situations. “The difficulty is that a retirement plan typically selects only one fund family, and therefore only one glide path, for all its investors. We think it would be appropriate for the industry to evolve to a point where investors have more glide path choice, so they can keep their investments in sync with their evolving risk capacities and preferences,” he said.

Given the importance of target-date funds to the financial security of an increasingly large number of investors, Bare contends there are an inadequate number of target-date benchmarks. He said the benchmarking challenge can be approached by breaking a fund down into dis­crete pieces. Target-date methodologies can be split into three key components that can be evaluated separately – asset class diversity, security selection, and risk control or the methodology that adjusts the asset allocation to synchronize the portfolio’s risk profile over the investment horizon.

Morningstar suggests the major asset classes in terms of target-date fund relevance are stocks, bonds, commodities, real estate, Treasury Inflation-Protected Securities, and cash.

Addressing Participant Behavior

On a positive note for target-date funds, Dallas Salisbury, president, Employee Benefit Research Institute, told the DoL and SEC that the use of target-date funds – regardless of the fund’s characteristics – tends to move participants’ overall asset allocations in 401(k) plans away from all-or-nothing allocations in equities and provides for greater rebalancing of assets toward more conservative investments as the participant ages, when compared with 401(k) participants’ voluntary investment decisionmaking.

“This results in participants having a theoretically superior long-term asset allocation based on taking larger risks when they are young and lower risks as they get closer to retirement,” Salisbury contended.

He said it is well known that a significant portion of 401(k) participants have their balances invested in a manner that does not conform with asset allocations that would be recommended by most financial advisers. A sizeable percentage of 401(k) participants have no equities. Overall, 13.2% of the 401(k) participants in the year-end 2007 EBRI/ICI data base fell into this category, according to Salibury.

In addition, Salibury noted, a sizeable percentage of 401(k) participants still have a significant percentage of their balances invested largely in company stock. Overall, 14.5% of the 401(k) participants in the year-end 2007 EBRI/ICI database who were in plans with company stock had more than 50% of their account balances invested in company stock.

David A. Krasnow, president, Pension Advisers, also noted that most participants have little to no investment experience, and do not spend the time reviewing the fund options, which is necessary to make investment decisions suitable for their age, risk tolerance, and time horizon. Once funds are initially selected, most participants do not monitor those funds or adjust their asset allocation during their working years, he said.

According to Krasnow, even when financial consultants advise participants to make portfolio changes, participants fail to utilize the recordkeepers’ telephone and Web-based systems to implement those changes.

Krasnow said the participants his company encounters repeatedly voice the desire to have someone invest and manage their retirement savings for them, and conceptually, target-date funds would satisfy that need.

However, Krasnow suggested additional disclosures are needed to fully explain the methodology used to construct the portfolios so that plan sponsors can properly select and monitor fund performance.

Plan sponsors are not aware of the differences, often selecting a target-date fund family solely on past performance. In addition, they have not performed any due diligence to determine which methodology is appropriate for the plan participants.

Actual participant behavior is one factor that should be taken into consideration when selecting a target-date fund, Krasnow contended. As an example, he said, sponsors should ask: When participants terminate employment, are they leaving their savings invested in the retirement plan until they actually retire, or are they rolling that money over to another investment account, which may not follow the same investment strategy?

In addition, for many years, participants were told “don’t put your eggs in one basket, diversify,” Krasnow noted. As a result, participants are not currently utilizing target-date funds appropriately. They select multiple target-date funds without realizing the fund manager is diversifying for them. Other participants think that the fund “matures” on the date cited in the fund name and savings are then invested 100% in lower risk securities.

“Participants need to be better educated about the purpose of this type of investment option,” Krasnow concluded.

A Webcast of the DoL/SEC hearing on target-date funds, as well as the written comments, can be accessed on the SEC Website at www.sec.gov.