Invest-O-Matic
Ron Popeil, the TV salesman extraordinaire of kitchen gadgets, stuck a clever slogan—”Set It and Forget It!”—on his latest labor-saving wonder, the Ronco Showtime Rotisserie. The sales pitch makes roasting prime rib, lobster tails, and shish kebabs to perfection look effortless indeed. However, it’s never as simple as set and forget: You need to know what cuts of meat stand up to the rotisserie, and how to season and truss the things, and how to load the oven so your turkey or tri-tip roast doesn’t fall off the spit, and then look in occasionally to see that it all hasn’t caught fire or been eaten by the dog.
As catch-phrases go, “set it and forget it” is a good one, and it has joined the lingo of defined contribution—to describe how target-date retirement funds adjust their investment risk, through a pre-set glide path that takes greater risk early on, and gradually trims equity exposure to appropriate levels over a participant’s career with a final target at, or shortly after, retirement age. Some advisers are skeptical of lifecycle funds, however, saying that a one-size-fits-all approach does not address individual needs—and perhaps fearing that, in a world of low-touch investments, they’ll lose their face time with sponsors. However, with more than 80 families of target-risk and target-date products in the market and more arriving regularly, each incorporating variations of investing philosophies and tactics, clients still need plenty of help to select the funds best-suited for their participants.
A Growing Market
After 20 years of educating, advising, and cajoling 401(k) participants to invest for the long term at the right levels of risk, plan sponsors are embracing the predetermined, self-adjusting investment allocations of target-date retirement, or lifecycle, funds. Just $8 billion of target-date funds were purchased in 2000 and 2001, but new investment reached $58 billion in 2006, reports Boston-based fund researchers FRC Corporation. “Target-date funds aren’t perfect, but they are the best solution available in the market for the great majority of 401(k) participants—that large group that doesn’t interact with their plans at all,” says Registered Investment Adviser Mark Davis, a principal in Kravitz Davis Sansone of Encino, California, advising $1.2 billion for retirement plans from Dallas to Waikiki.
Fund companies have flocked to the growing target-date market, each trying to present a differentiated product; as a result, deciding on a lifecycle program is far more complex than investing in one (see sidebar).
The central issue in finding the right lifecycle fund suite to put on a retirement plan’s investment menu, believes Davis, is the sponsor’s attitude toward risk and time horizon. “Is your focus on longevity risk, and the possibility that participants might outlive their savings?” he asks, “Or the volatility of annual returns, and the risk that participants will back away from a fund because of swings in the market?”
Although sponsors may think they have a sense of their participants’ attitudes and potential retirement outcomes, their hunches need to be confirmed with detailed research on actual contribution rates and investment postures, says Kurt Hettel, Managing Director at RSI Financial Services, an adviser in Mount Laurel, New Jersey. “Statistics show that half of participants don’t change their strategies over long periods,” he adds: “To me, the lifecycle fund is probably the best choice for many participants.”
However well it may suit inert participants, some advisers remain threatened by the idea that these investment choices can be selected by the plan sponsor with little—or no—involvement by the adviser. However, today, many—if not most—advisers are embracing the structure enthusiastically as a way to free them up to focus on other aspects of retirement plan design, including plan sponsors’ fiduciary liabilities and participant deferral rates.
Varying Philosophies
“I tell clients to look at the lifecycle fund decision like a religious question,” says Davis. “All the world’s religions have a different view of what the afterlife is and how you achieve it,” he explains, “but only one is going to be right and, by the time you know what the true path is, it will be too late to do anything about it. So, I tell my clients to be sure they have faith in the risk approach of each fund family, because you’re hiring an investment manager for your participants’ lifetimes.”
“We start with what the allocation to equities should be in retirement,” explains Frederik Axsater, head of DC investment strategy for Barclays Global Investors in San Francisco. (The firm lays claim to inventing the target-date concept 14 years ago, with its LifePath funds.) “In 1993, we started with a 20% equity allocation, because that was the norm at the time. Then, in 2000 and 2001, we ran a lot of simulations, and found that the equity allocation should be as high as 35%,” to accommodate investors’ drawing more from their accounts earlier in retirement, and drawing more erratically, to pay for rising health-care costs.
Advisers and sponsors also should inquire about how a manager intends to react to changes in market “regimes,” such as settings of high inflation or interest rates. “For us, there is no such thing as “set it and forget it,”” says Douglas DuMond, Managing Director at BlackRock Corporation in New York, which introduced its Prepared Portfolios in May 2007. “The glide path of a target-date fund is a risk budget that, just like a DB plan, has to be reviewed every year to take account of market shifts. To manage that, we have a 35-person team of portfolio managers and actuaries developing multi-asset strategies, while most target-date funds just run on optimized models.”
Another important philosophical factor that sponsors and advisers need to take into account are the portfolios’ sources of return. Many fund families have built lifecycle funds to capitalize on their existing records in active management—examples are AllianceBernstein, T. Rowe Price, Putnam Investments, and JPMorgan. Others, like Vanguard, believe the combination of market returns and low-cost index funds will win. Barclays Global Investors offers both active and passive approaches by building with index and enhanced index funds: “With the lifecycle family built with enhanced index funds,’ says BGI’s Axsater, “you have all the benefits of an index approach—risk control and being true to your allocation—but you also have the ability to add some alpha.’ BlackRock goes even further, adding traditional active management to passive and enhanced options.
A few fund companies are mixing active and passive in one offering. At Russell Investment Group, Senior Strategist Grant Gardner reports, “Where we go passive is in the most efficient asset classes—large-cap U.S. and international equities, and the U.S. bond market.’ Advisers also cited a combined active-passive offering, currently available only to large plans, from Pyramis Advisors.
Gardner points out another dimension to the active-passive debate: “It’s not enough to say active management can add return net of fees. Sponsors are sensitive to their fiduciary responsibilities as well as costs and, in those situations, passive investing, or a mix of passive and active, can be the right solution.’
The passive-active combination appeals to Randy Long, Managing Principal at SageView Advisory Group, Irvine, California: “Fees matter, of course, so you have to look at balancing the fees against the extra return from active management. Active managers can add value in the small-cap and international markets, but less so with large-cap stocks.’
Long is leery, however, of target-date funds where portfolio management is concentrated in one firm. “They’re not going to fire themselves for underperforming,’ he notes. In general, he is not yet satisfied with what he has found on fund company shelves, and so has created his own combined active-passive lifecycle portfolios from mutual funds he and his clients already know. “We like to create custom portfolios for our clients with a fund lineup from a variety of managers, and make an active-passive decision separately on each asset class. We’re hoping we can manage down the expense ratios,’ he explains, “and we can replace one manager for one asset class at a time.’
Other advisers believe that managed account structures offer better inherent value and, before long, will displace lifecycle funds. “I visited one of the top asset management firms, one that recently introduced a lifecycle fund,’ says Chip Morton, an adviser for medium to large plans with Raymond James Financial in Destin, Florida. “I told them the product was impressive, but not to put too many resources into it, because, as great as it could be, a managed account program is simply a better choice. I can do my own due diligence, and pick the best-of-class fund for each asset class from the hundreds of funds on any given vendor’s platform.’ A second advantage, he says, is that the recordkeeping system of a managed account platform builds an asset-allocation model based on the participant’s financial situation, not just an average expected retirement date. Moreover, the involvement of a third-party asset-allocation expert, such as Ibbotson Associates, adds expertise, vets the fund choices, and spreads out fiduciary responsibility. “Managed accounts don’t take away the advisership role,’ Morton adds. “You’re still selecting which funds the plan will invest in. I think we should just jump over lifecycle funds and go straight to managed accounts, but not all of the recordkeeping systems can handle that right now.’
Similar, but Different
When you ask the lifecycle managers themselves, they describe two major differences among portfolios. The first is investment efficiency—diversification through breadth of the asset mix. Most target-date funds invest in the full capitalization and style range of U.S. equities, but there are wide variations in their holdings of bonds and international equities. JPMorgan’s SmartRetirement funds, for instance, can extend portfolios to emerging market equities and bonds, as well as REITs, and even direct real estate in a commingled fund version. BGI’s asset mix includes REITs and TIPS, and international REITs and bonds are under consideration, says Axsater. Russell Investment Group recently added a global equity fund, and BlackRock’s DuMond highlights “a tactical component to our portfolios, where we can over- or underweight from the glide path, taking a view based on our market intelligence.’
Fund managers seem most competitive about the glide path itself, which crystallizes how aggressive the portfolio is, and over what period. AllianceBernstein’s white paper, “Target Date Retirement Funds: A Blueprint for Effective Portfolio Construction,’ sums up the debate: “The primary flaw in most target-date retirement funds is that they invest too conservatively….They hold too little equity and too much fixed income and cash to generate the growth required to fund participants’ spending over what may be several decades in retirement.’ Of course, that perspective is not shared by everyone.
Yet, no matter how sophisticated the asset mix or aggressive the glide path, most observers agree that no target-date fund will bail out the participant who has not saved enough. “On the margin, the investment you choose will make a difference,’ comments Anne Lester, Portfolio Manager for JPMorgan’s SmartRetirement funds, “but no investment is going to make up for years of undersaving. There’s no quick fix—participants have to save more from the start.’
Therein lies the opportunity for advisers, says Davis: “Target-date funds are here to stay, and advisers who think that their role is just asset allocation are going to miss the boat.’ Participants and employers need advisers’ help in raising contribution rates, he adds, and, short of legislated mandatory contributions, “Face-to-face interaction is the only way to get people to take more money out of their pockets. Even if a fund offering is not perfect, I would rather use an off-the-shelf target-date fund, and the manager’s marketing and communications, than try to make my own. That’s the way for advisers to justify their seat at the table.’
SIDEBAR:
Decision variables
Investment philosophy
- Investment time horizon
- Ending at retirement
- “Cradle to grave’
Sources of return
- Active management
- Index investing
- Enhanced indexing
Risk profile
- “Glide path’ of risky assets (stocks) versus hedging assets (bonds) over time
Diversification
- “Classic’ asset classes
- “Extended’ asset classes
- Alternative assets
Investment tactics Portfolio monitoring Product structure