Target-date Funds Under the Microscope

questionsRobert Powell’s article on Marketwatch is a well written overview of the concern Congress has regarding these funds’ performance and construction, which consequentially were given Congress’s blessing in the ’06 Pension Protection Act. However, it was clearly stated in the PPA that a company’s fiduciaries must do their due diligence in reviewing these funds, just like the other investment options in the plan. If they need help in doing so, we would recommend hiring a fiduciary plan consultant to help you determine whether these funds meet the criteria of your plan’s Investment Policy Statement.
Changing gears, let’s take a behavioral look at these funds and how they are used by participants…

Target date funds are a great tool plan sponsors (companies) can use for investors who are just starting out or have small balances. In theory, they are designed to be a “one-stop-investment-choice” for the entire retirement accumulation phase of your life. However, in our experience, the vast majority of investors with larger balances (typically >$30,000) tend to stop using them correctly as a “one-stop-investment-choice”, and instead begin “diversifying” their fund with the hot funds of the time. For example, if you were to take a sample of investors in your plan right now, you would likely find those with larger balances to have the following allocations:

Multiple Target Date Funds (i.e., Fidelity Freedom 2020 and Fidelity Freedom 2040)Target Date Fund + Other Asset Class Funds – The usual suspects include international, emerging markets, and sector funds (most notably natural resources and healthcare if available in your plan) due to their returns pre-’08.Target Date Fund + Ugly Duckling – The ugly duckling fund is that fund you cannot get rid of due to the potential mutiny from your participants. Such funds we have seen like this include Fidelity’s Magellan, Janus Worldwide (still waiting for it to come back), etc.

Now, let’s look at how these “diversification” practices change the risk level in their portfolios.

Multiple Target Date Funds – It depends on the mix, but we have found a large number of TD investors will chase the returns of these funds. For example, during a bull market they will invest in the 2040 fund, while during a downturn they will do the same with the 2010 fund…just chasing returns.

Target Date Fund + Other Asset Class Funds – We typically see increased risk due to chasing the returns of stock funds such as the aforementioned usual suspects. Lately, we see the opposite, as people have thrown money into the cash/bond funds for safety. Either way, greed and fear are the root of the decisions…which usually does not work out well for the investor.

Target Date Fund + Ugly Duckling – These are typically stock funds, so an increase of risk wins again.

What options do companies have in combating this issue?

From Robert Powell’s article:

Managed accounts
Jason C. Roberts, a partner with Reish Luftman Reicher & Cohen, said one-size-fits-all funds serve no one well. “We have come a long way to come back to what we knew at the start,” he said. “Investment decisions require a great deal of unique input.”

Roberts is calling for the increased use of what he calls independent “asset allocators,” advisers who can custom-build 401(k) and IRA portfolios to the unique needs of each person.