Sunday, June 7, 2009

Target-Date Funds in the Spotlight

The Department of Labor and the Securities and Exchange Commission will hold a joint one-day hearing June 18 to explore issues that have been raised about target-date funds or life-cycle funds. These are funds that allocate assets into a mix of stocks and bonds based on the age of the investor, with higher equity allocations for younger investors. The poor performance of these funds in the market crash has raised issues about their appropriateness in employer-sponsored retirement saving plans.


By Robert Stowe England

June 8, 2009

The Department of Labor gave its regulatory blessing to target-date or life-cycle funds in the fall of 2007 at the peak of the market, giving employers the green light to offer these funds to employees who had not made a choice among the investment options in an employer's 401(k) plan.

DoL then identified target-date funds as one allowable choice for so-called qualified default investment options (or QDIA's in the lingo of the bureaucrats). For more information on QDIA's go to this DoL link: http://www.dol.gov/ebsa/newsroom/fsqdia.html

Target-date funds allocate the assets in the fund among stocks, bonds and other investment options to represent a risk level appropriate for the investor, based on the investor's age.

The basic concept behind such funds is that the share of money invested in equities should be highest for young people and lowest for people near retirement in order to obtain the best overall returns and to protect gains as one nears retirement. Conversely, the share of bonds should be lowest for young people and highest for people near retirement.

Underlying target-date funds is the fact that equities over time earn a premium over bonds while equities also represent a riskier investment class. However, it is also true bonds can out peform stocks for extended periods of time, as reported in an article in April on this blog at this link: http://mindovermarket.blogspot.com/2009/04/are-bonds-new-stocks.html

Further, sharp contractions in the value of equities, such as occurred after the burst of the dot.com bubble in 2000 and the market meltdown that followed the failure of Lehman Brothers in September 2008, lead to sharp losses that can take many years to recover.

Despite the promise of target-date funds, the early evidence indicates that they fared very poorly during 2008, especially the 2010 funds -- which are funds designed for people only two years away from retirement. Heavy losses in these funds mean that investors have little time to make up the losses.

To be sure, one would be hard pressed to find any investment approach that fared well during the market meltdown of 2008, except broadly shorting the market and betting against mortgage-backed securities, Wall Street firms and banks -- all strategies that would not be available to most employees in their employer-based 401(k) plans and other retirement saving plans.

Financial adviser Chris Tobe describes target-date funds as "a distastrous choice for participants in 2008" in an article posted to this writer's Web site at: http://www.robertstoweengland.com/documents/Chris%20Tobe_OffTarget.pdf. Tobe currently does consulting work for Breidenbach Capital Consulting and is a trustee for the Kentucky Retirement Systems LLC in Louisville.

Tobe compares the comparative abysmal performance seen in official data from Fidelity Investments and the Thrift Savings Plan, which is the retirement savings plan for federal civilian employees.

The losses in the 2010 funds are, of course, the most troubling, since retirement for these investors was theoretically only two years away last year. Fidelity's 2010 funds declined 25.32 percent, while the Thrift Savings Plan's 2010 funds declined 10.53 percent. Even pure income funds with no equities did not do well in the 2008 crash. Fidelity's income funds fell 12.14 percent, while the Thrift Savings Plan's income funds fell 5.09 percent.

In an article in Main Street, Janet Aschkenasy warns investors that while target-date and life-cyle funds have similar names, the actual allocation of assets to equities, bonds and other classes for the same target date can differ widely. The article can be found at this link: http://www.mainstreet.com/article/retirement/how-keep-your-retirement-target

"In fact, the huge variation in the amount of stock that goes into different fund companies' target-date recipes has experts wondering whether the names of the funds should change to reflect their level of risk," Aschkenasy writes.

She cites a recent study by Financial Research Corporation in Boston that equity allocations in 2020 funds can range from 51 percent to 90 percent.

Last year the Senate Aging Committee has looked into target-date funds under Chairman Herb Kohl (D-Wisconsin) and likewise found "a wide variety of objectives, portfolio composition and risk within the same-year target-date funds."

Craig Copeland of the Employee Benefit Research Institution in Washington, D.C. studied the use of target-date funds in 401(k) plans in 2007, before the market meltdown. He also found a range of equity allocations within each target-date category. The study can be found at this link: http://www.ebri.org/publications/ib/index.cfm?fa=ibDisp&content_id=4203

Copeland found that as of 2007, the equity allocation ranged from about 80 to 90 percent for 2040 funds. For 2010 funds the range was from 26 to 66 percent -- a startling 40 percentage point difference.

"This analysis finds that the relative rank of the equity allocation within a target-date fund does not appear to affect the percentage of participants investing all their account into that fund. Nevertheless, investors in specific fund families are more likely to invest all their assets in a single target-date fund from that family," Copeland writes.

Ibbotson Associates published a report in May that advises employers on how they can create target-date funds within an employer plan to meet employee needs. The study is at this link: http://corporate.morningstar.com/ib/documents/TargetMaturity/CreateCustomTgtMatFunds0509.pdf
"A plan participant’s asset allocation is the most important determinant when assessing return. More than 90 percent of the variability of returns associated with a portfolio is determined not by buying and selling securities or trying to time the market, but through the power of asset allocation," the report claims.

The reports cites a study by Roger Ibbotson and Paul D. Kaplan, titled "Does Asset Allocation Policy Explain 40 Percent, 90 Percent or 100 Percent of Performance?" in the January/February 2000 issue of the Financial Analysts Journal. Here is a link to an abstract of the article: http://www.cfapubs.org/doi/abs/10.2469/faj.v56.n1.2327

The clear message to investors is to learn more about a given target-date fund before deciding to invest in it. One cannot take comfort in the fact it is a target-date fund, given that there are no hard definitions about the asset allocation or level of risk.

Employers, too, cannot rely entirely on the fact that under Department of Labor rules, target-date funds are qualified default investment alternatives (QDIA's) in a company's 401(k) plan. They are still liable as fiduciaries in choosing an appropriate set of target date funds for employees in the fund. Janet Aschkenasy takes a look at fiduciary issues for employers surrounding target-date funds in an article in Treasury & Risk at this link: http://www.treasuryandrisk.com/Issues/2009/April%202009/Pages/Target-Date-Troubles.aspx

Tobe also warns employers that the "DoL emphasized that the selection of default investment option must be prudent."

It will be interesting to see what sort of testimony will be given at the upcoming joint hearing on these funds by the Department of Labor and the Securities and Exchange Commission.

The hearing will be available via webcast on the DoL's Web site at http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.dol.gov/ebsa and on the SEC Web site at http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.sec.gov.

More information on the DoL/SEC hearing can be found at this link: http://www.dol.gov/federalregister/HtmlDisplay.aspx?DocId=22701&Month=5&Year=2009

Copyright 2009© by Robert Stowe England

2 comments:

Anonymous said...

Not all target date or life cycle strategies are made up of Mutual Funds and ETF's.

Robert, I would suggest leaving out opinions and cliche'ed anecdotes from the article.

Caliban said...

Thanks for the correction on what funds can be described as target-date funds. I removed 'mutual funds' as a description and the text should now read just 'funds.'

As for opinions, I did try to include links, quotes and citations from a range of views.