Target date woe
Target date funds (TDF) are still the fastest growing investment option in US 401(k) plans. They have survived the recent hearings held jointly by the Securities Exchange Commission (SEC) and the Department of Labor (DOL), and the industry's fear that they were going to be constricted by new heavy rules has waned. But investment companies and plan sponsors must better explain TDF risks to workers if they want to grow further.
Will analysts and consultants be able to transform this problem into an opportunity to launch new services? A case in point is this September's launch of new ratings and in-depth research reports for TDF series by Morningstar: each fund series will be evaluated according to five different components - people, parent, performance, portfolio and price - and will receive a maximum score of 100 points (20 points per component), with one of five ratings: top, above average, average, below average and bottom.
TDFs started to become more popular in 2006, when pension legislation encouraged employers to automatically enrol workers in 401(k) plans and invest their contributions in these funds, designated by the DOL as qualified default investment alternatives (QDIAs).
TDFs are designed to give participants a complete and simple retirement investment solution in a single fund: the target date refers to the year of retirement; as time passes, the diversified portfolio of stocks, bonds, cash gradually shifts to a more conservative asset allocation to reduce risk as the retirement date nears.
TDFs grew to $187bn (€132bn) as of last May, up from $164bn at the end of 2008 and $71bn in 2005. But last spring, participants in TDFs with a retirement date of 2010 were shocked when discovering that in 2008 they had lost on average up to 20%, with extremes of 40%. The popular Fidelity Freedom 2010 fund, for example, lost 30% of its value in 2008.
Fidelity, Vanguard and T Rowe Price together manage 80% of all TDF assets. Their clients were surprised because, being so close to retirement, they expected their portfolios to be much more conservative, almost entirely invested in fixed income. Instead the top five 2010 target-date funds had an average equity exposure of 57% in 2008, and some 2010 funds even had equity exposures of 85%. That sparked investigations by the SEC and DOL.
"Industry players were concerned that legislators would get involved in asset allocation, imposing rules on the way TDFs are designed," says Morningstar analyst Michael Herbst, a TDF specialist. "One big benefit from the hearings is that they clarified there is a lot of misunderstanding about TDFs: many people thought they were all safe. In reality there are a lot of different assumptions and guesses behind TDF design and it's difficult to compare them. That's why Morningstar is launching the new ratings."
"Investment companies have looked differently at life expectancy statistics, which show that if both spouses at 65 are alive they have 50% chance of reaching 90," says Richard Menson, a lawyer with McGuireWoods and an expert in fiduciary problems. "So, for example, T Rowe Price has designed TDFs heavy in stocks also at retirement age, because they are expected to provide income and capital gains until participants are 95 years old. Of course these funds do not guarantee they don't go down. The lesson for plan sponsors is that TDFs are not a panacea: choosing them is still a very delicate fiduciary duty, especially regarding which glide path is appropriate for the plan participants".
A glide path is a fund's strategy for reducing risk by adjusting asset allocations as the target date gets closer. "We recommend our clients to better educate their plan participants about these problems and to be careful to match their expectations and needs with the right TDF," adds Menson. "If participants expect their accounts to be virtually risk-free at retirement, it may be best to choose a target date fund with a glide path that ends at retirement. Plan fiduciaries may want to consider adding more than one TDF date fund family to a plan's investment options to allow participants to choose between different glide paths".
The pressure on TDFs has eased somewhat. "2009 has been a good year so far and our 2010 fund is up 11% [as at end-July]," says Steve Utkus, principal at the Vanguard Center for Retirement Research. "And in 2008 our TDF participants were less likely to panic and abandon equities than other investors, because their portfolios were better balanced."Target date woe