Are Target-Date Funds the Ideal Default Investment Choice?

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    Target-Date Funds: Not the best choice

    With over $ 270 billion in assets, 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.

    One of these major shortcomings occurs when a person actually reaches the end of their target date.

    The big question is: How should the money be invested when that final date is reached?

    When they were first launched, this question was raised, and frequently dismissed, by portfolio managers as being too far into the future to worry about. That is exactly 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 basically said: “We’ll worry about that when the time comes.”

    But that never answered the questions: 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 the “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.  But 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 difficult to justify.  This is complicated because old people may be better using annuities or paying down their house with the 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 the fact that 80% of persons reaching retirement age withdraw all of their account money at retirement.  Their policy may also be driven by keeping the assets under management and inside the fund to boost company profits, he added.  This policy is currently followed by some of the largest names in the TDF industry.

    His simple answer is that “you don’t need a standardized glide path at retirement.”  The best alternative, from the investor’s perspective, is to go to cash. That gives them a clean slate to develop a more personalized investment plan, he said.

    Other Problems Persist

    While the glide-path scenario remains 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 prior to, and at, the target date.”  This helps explain why TDF investors were “brutally punished” by investment losses since November 2007 by strategies that were too aggressive.

    Not enough asset classes.  TDFs do not include enough different asset classes, and while the industry touts the number of “approved asset classes” or “target allocations,” the reality is that that “fund companies only pay lip service to diversification.”

    More passive management needed.  The analysis found that the industry “continues sacrificing returns in their superstitious preference for active over passive management.”   The investment losses due to pursuing active strategies are borne by investors.

    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 cleverly package in-house funds, many of them rated as mediocre, into a new package which relegates their weak individual performance less noticeable when it is mixed with the active management of the glide path and the asset allocation formula.

    In all cases (with the exception the ETF TDFs), TDFs are comprised of mutual funds from within the same mutual fund company offering them.  But 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 which makes collective trusts more attractive.  As more pressure builds on fund companies to lower costs as a result of the upcoming DOL fee disclosure provisions and investor concerns, collective trusts have the ability to  move away from off-the-shelf fund into more customized funds, including TDFs with customized glide paths comprised of index funds.  This would be attractive to very large and large 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 there is more room from other large fund companies to reduce fees if they were pressured.

     

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    Chuck Epstein has managed marketing communications and public relations departments for major global financial institutions and participated in the launch of industry-changing financial products. He also has written by-lined articles for over 50 publications, five books and served as editor and publisher of nation’s first newsletter on the topic of using the PC for personal investing and trading. (“Investing Online, 1994-1999). He also is a marketing consultant, writer and speaker on topics related to investor protection and opportunities in the very dynamic cannabis industry. He has held senior-level marketing, PR and communications positions at the New York Futures Exchange, Chicago Mercantile Exchange, Lind-Waldock, Zacks Investment Research, Russell Investments and Principal Financial. He has won national awards from the Mutual Fund Education Alliance (MFEA) and his web site, www.mutualfundreform.com, was named best small blog in 2009 by the Society of American Business Editors and Writers (SABEW).

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