Searching for Clarity

In a joint hearing about target-date funds before the Department of Labor (DoL) and the Securities and Exchange Commission (SEC) in June, witnesses were in favor of the use of target-date funds, but said the current market for the funds is flawed.

In opening remarks, DoL Deputy Secretary Seth Harris noted that concerns have been raised recently 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 from actuarial assumptions of participant life expectancy that he thinks lead to a too-high equity allocation at age 65.

In his testimony, 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.

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 ½, he said.

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 profiles are radically changed from income generating to income consuming—something that target-date funds do not generally take into account, he argued.

Glide Path Structure

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 are 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, he noted.

Instead, Coons suggested it is important for target-date fund managers to communicate effectively 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 also should 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.

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.

Nagengast 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’ attempt to use the key engine of target-date funds, the glide path, for purposes other than its primary function—which, in his opinion, 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. Nagengast’s suggestions included that: the name of each fund must bear some relationship to its glide path end point (i.e., if a fund labeled 2010 is really targeted to “land” at 2040, it should be relabeled as a 2040 fund); the glide path must be designed to provide for a predominance of asset preservation as the target nears and arrives; and prospectuses should be clear about the objectives of the funds—specifically, no circular definitions of fund objectives should be allowed.

“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 overdiversified and underdisclosed. 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 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 is 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,” said Bare.

He 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

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

He 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 explain fully the methodology used to construct the portfolios so that plan sponsors can select and monitor fund performance properly. 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 currently are not 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 then are invested 100% in lower-risk securities.

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