Target-date funds have been a boon to the investment industry, helping to get people to save for retirement, but some big changes could be coming soon aimed at making sure nest eggs are better protected.
Introduced in the early 1990s, the majority of defined contribution plans now default into a target-date or other professionally managed account. The asset allocation in such funds becomes more conservative as the target date (usually retirement) approaches.
Related story: Growth ahead in managed accounts, TDFs
TDFs were created because “Americans are terrible at investing,” said Ric Edelman, CEO of Edelman Financial Services in Fairfax, Va., and author of numerous books on investing. “They either take too much risk or too little risk and they enter and leave the stock market at the wrong time.”
He believes that the premise behind TDFs remains a good one: Get people to save who wouldn’t normally save and place them in a managed, diversified portfolio that becomes less risky as they age.
“Given the choice of letting the worker fend for himself and figure out what to invest in and when vs. using professional management offered by the fund, for most workers, they are better off in a TDF,” he said.
But problems have arisen.
In 2008, when the market took its latest nose-dive, many Americans lost up to 40 percent or more of their retirement accounts because they were invested in target-date funds. The losses cast a light on the many ways target-date funds are set up and sparked much debate among industry participants, the Department of Labor and the Securities and Exchange Commission.
Many of those who suffered losses in the ’08 meltdown were invested in 2010 target-date funds, so their investment in equities should have been lower and their investment in bonds higher since they were so close to retirement. That was not the case.
See also: A moving target
Some TDFs have a “to” glide path, meaning the assets in these accounts will be invested more conservatively every year as the owners get closer to their retirement year.
Alternatively, TDFs with a “through” glide path also get more conservative over time, but their managers try to balance the portfolio based on the assumption people will live to be age 90 and that they will still need to be earning money on their investments until they reach that age.
Edelman believes there are two things that can be done to improve the TDF market: tighten rules limiting their diversity, so there isn’t that much difference between one fund and another and, not surprisingly, get workers better educated about how these funds work and how to take advantage of them.
In April, the SEC’s Investor Advisory Committee agreed that most individual investors are ill-equipped to identify the risk disparities among similar-seeming funds. It also found that many professional pension fund consultants underestimate the degree of risk in many target-date funds.
To underscore the disparity point, a recent Morningstar study of 36 funds with a target date of 2020 found that their equity weightings ranged from 35 to 80 percent.
So the committee urged its overseers at the SEC to develop an alternative glide path illustration based on the target risk level over the life of the fund.
A glide path illustration based on an appropriate, standardized measure of fund risk would be more accurate and more flexible than a glide path illustration based on asset allocation alone, the committee concluded.
The committee also recommended that the SEC require TDF prospectuses to disclose and clearly explain the policies and assumptions used to design and manage the target date offerings to attain the target risk level over the life of the fund.
Fees also need to be detailed, it said, so investors will know how much of their money will go toward administration of the funds.
The SEC hasn’t made a final decision about whether or when these recommendations might be implemented.
There’s plenty of disagreement on what the best approach should be.
Dr. Gregory Kasten, founder and CEO of Unified Trust Co., a retirement service provider to employer-sponsored plans and individuals, believes that TDFs should never be managed on a “through” glide path.
Unless plan sponsors know their employees plan to keep their money in the employer-sponsored plan until they die, they should “assume they are not going to do that,” Kasten said.
That means companies should manage their plans to a more conservative landing point because it is very unusual for people to stay in a job for 25 years and keep their money in the company-sponsored plan when they retire, he said. Most people roll their accounts over to an IRA when they leave a job because they want greater control over their money.
Another problem with TDFs, many say, is that each one has a different asset allocation and there are hundreds of funds associated with each potential year of retirement. Also, many workers misuse TDFs. Instead of investing all of their retirement assets into this type of fund, they put some money in a TDF, some in stocks, some in IRAs and other retirement vehicles.
“When they do that, they are destroying the asset allocation the fund is designed to provide,” Edelman said.
Also, Kasten noted that many TDFs are actively managed while some are passively managed.
Data from Morningstar and Standard and Poor’s show that passively managed funds outperform actively managed funds, so he questions why a plan sponsor would take on higher fees and lower returns on the off chance they will do better.
Scott Donaldson, a senior investment analyst in Vanguard’s Investment Strategy Group, acknowledges TDFs aren’t perfect but believes they can serve a very important purpose in defined contribution plans if they are used correctly and plan sponsors do their due diligence in picking one that best meets the needs of employees.
Fees, of course, also are important.
“The less you pay for access to a particular investment class, the better your returns will be over the long run,” Donaldson said.