With over $2.8 trillion in assets at the end of 2088, target-date funds (TDFs) continue to be the default provision favorite for millions of future retirees as part of the Pension Protection Act of 2006. But despite their wild popularity, TDFs have yet to overcome what many consider some fundamental design flaws that make them the less-than-perfect default investment choice for millions of investors.
Planning for retirement may seem tedious, but it is one of the most important a person can make since it determines how much money they have for the decades they can live after retirement. That’s why it is essential to have a retirement checklist.
One of these significant shortcomings occurs when a person reaches the end of their target date and enters retirement.
This checklist can help solve the big question: How much money should I have at retirement, and how should it be invested when the retirement date is reached?
When they were first launched, portfolio managers raised this question and frequently dismissed it as too far into the future to worry about. That is precisely what a portfolio manager told me when I asked about the final disposition of the glide path when the fund hit its stated end date. He said, “We’ll worry about that when the time comes.”
But that never answered the question: Would the asset mix remain the same? Would the fund go to cash? Would the funds be dispersed to participants? Or would the funds be rolled into a fixed-income account?
The suggestions were varied but never resolved. According to Joe Nagengast, a TDF specialist and co-author of “Popping the Hood III: An Analysis of Target-Date Fund Families,” the problem stems from a disconnect break between the asset mix in the accumulation phase versus the distribution phase. This problem occurs because there is no logical connection between the two or because a demographic observation did not translate into an investment strategy.
Specifically, he noted that one TDF model called for investors to hold more equity towards the end of their glide path because they had a life expectancy at 65 of 30 or so more years. While that may be true in longevity terms, it “had nothing to do with investing,” he said.
The basic problem, he said, is that managing assets for 20-year-olds is very similar in terms of their risk tolerances and time horizons. However, that changes dramatically as people age; health, marriage, job, and family situations change, some dramatically, so putting more assets into bonds or equities becomes more challenging to justify. This isn’t easy because old people may be better off using annuities or paying down their house with target-date assets.
The policies of TDF portfolio managers who follow this “through-fund” model of active investing past the target date end period seem to ignore that 80% of persons reaching retirement age withdraw all of their account money at retirement. He added that their policy may also be driven by keeping the assets under management and inside the fund to boost company profits. Some of the most prominent names in the TDF industry follow this policy.
His simple answer is that “you don’t need a standardized glide path at retirement.” From the investor’s perspective, the best alternative is to go to cash. He said that gives them a clean slate to develop a more personalized investment plan.
Other Problems Persist
While the glide-path scenario remains a problem, the “Popping the Hood III” analysis also found other significant problems in these areas:
Risk management. The study found many TDF families “continue to pay too little attention to risk, [are] too aggressive, especially just before, and at, the target date.” This helps explain why TDF investors have been “brutally punished” by investment losses since November 2007 due to too aggressive strategies.
Not enough asset classes. TDFs do not include enough different asset classes. While the industry touts the number of “approved asset classes” or “target allocations,” the reality is that “fund companies only pay lip service to diversification.”
More passive management is needed. The analysis found that the industry “continues sacrificing returns in their superstitious preference for active over passive management.” Investors bear the investment losses due to pursuing active strategies.
Reduce the fees. The report found that while some new entrants have entered the market with lower fees, the overall fee levels “continue to remain high.”
Lower Expenses and Collective Trusts
While TDFs remain extremely popular with investors, they have also been a marketing miracle for fund companies. One reason is that they cleverly package in-house funds, many of which are rated as mediocre, into a new package, making their weak individual performance less noticeable when mixed with the active management of the glide path and the asset allocation formula.
In all cases (except the ETF TDFs), TDFs comprise mutual funds from within the same company offering them. While the funds may be mediocre, Nagengast noted that the power of portfolio diversification and glide path design more than compensates for the mediocrity of the individual components. While that is beneficial, it still does not resolve the “big deal issue of costs,” he said.
This is the issue that makes collective trusts more attractive. As more pressure builds on fund companies to lower costs due to the upcoming DOL fee disclosure provisions and investor concerns, collective trusts can move away from off-the-shelf funds into more customized funds, including TDFs with customized glide paths comprised of index funds. This would be attractive to substantial funds, which could take advantage of their size and buying power, according to Nagengast.
How much would a collective trust charge in fees?
As little as 20 basis points or less for TDFs using index fund components, he said. “Many collective trusts could build TDFs with fees that beat Vanguard,” he said. Even then, he indicated more room for other large fund companies to reduce fees if pressured.
