See this year's 401(k) Buyer's Guide.
So much for autopilot. Amid all the recent tumult in the 401(k) space, one area that plan sponsors may have thought was trouble-free is anything but. Target-date funds — premixed portfolios that automatically get more conservative as an investor's retirement date approaches — are marketed as an ideal way to simplify investing: all a participant has to do is specify his or her expected retirement year and the fund manager does the rest.
But for a plan fiduciary, choosing a target-date lineup is far from easy. The funds vary enormously from one provider to another — a fact driven home last year when some of the biggest losses were suffered by participants on the verge of retirement, who supposedly had the most conservative portfolios. The average 2010 fund (that is, a fund allegedly tailored to an employee due to retire in 2010) lost 23.3%. Some fared far better, with the best losing just 3.6%; but some fared dismally, with the worst-performing 2010 fund losing a stunning 41.3%.
These huge disparities underscore a poorly understood reality: target-date funds differ dramatically in asset mix and in "glide path" — the rate at which the asset mix changes over time. "Participants who rely on date alone to choose a fund can have much more exposure to market volatility than they realize," says Tom Idzorek, chief investment officer and director of research at Ibbotson Associates, a Morningstar subsidiary. Indeed, the percentage of equities in 2010 target-date funds ranges from 14% to 65%.
Rediscovering Risk Tolerance
In February, Morningstar introduced a new rating system to make it easier to compare and benchmark target-date funds. The company has 13 target-date asset-allocation indexes available in three risk profiles — aggressive, moderate, and conservative. The index allocations adjust over time, reducing equity exposure and shifting toward income-producing and inflation-hedging asset classes. Morningstar has also now grouped the funds into five-year categories. Previously, they were lumped into three broad groups: 2000–2014 funds, 2015–2029 funds, and 2030+ funds.
"Now that everyone has rediscovered what risk tolerance means, plan fiduciaries may want to limit themselves to target-date funds with a more conservative glide path," says Idzorek. The trade-off: a conservative fund may provide more-stable returns around the investor's retirement date, but it won't necessarily generate the growth needed to support decades of retirement.
In addition to risk tolerance, Idzorek advises sponsors to consider "the human-capital characteristics" of the plan population — that is, how likely is it that participants will need to tap their 401(k) savings long before their retirement dates? "Tenured university professors are better candidates for an aggressive [that is, riskier] glide path, given their secure employment, than are stock brokers, who face a more unpredictable career outlook," he says.
A target-date family's underlying components typically come from a single financial provider, and often include weak proprietary funds. (An object lesson: the Oppenheimer 2010 Target-Date Fund's 41.3% loss last year was due both to its 65% equity allocation and to the fact that its core bond holding was heavily invested in mortgage-backed securities.) "If the plan sponsor thinks one or two of the underlying funds aren't any good, there's usually nothing he can do about it," says Robyn Credico, national director of Watson Wyatt's defined-contribution practice. "The financial provider decides what to put into target-date funds, and in what proportion."
One way to avoid weak proprietary offerings is to opt for passive rather than actively managed underlying funds. Passive funds are also easier to monitor since there's no need to stay abreast of fund objectives and managers' strategy, and they're less expensive. Target-date funds with actively managed components can be pricey. Morningstar says fees for 2010 funds range up to 1.5%, for example — a steep price for a broadly diversified fund with a big fixed-income exposure.
Last but not least, participants should be cautioned to consider their risk preferences and total financial situation in selecting a fund — not just their retirement date. "If Social Security and a defined-benefit plan will be a substantial part of your retirement income, for example, you can afford a more aggressive glide path," says Idzorek. "If not, you may want to consider a more conservative path."
Reasons to Believe
Last year's wake-up call seems unlikely to dent target-date funds' popularity. Almost 80% of 401(k) plans offer them, attracting contributions from 37% of their participants; and 53% of the employers who don't yet offer them will do so this year, according to Hewitt Associates.
It's easy to understand why. At their best, target-date funds can boost 401(k) participation, improve participants' investment portfolios, and reduce the sponsor's fiduciary liability at the same time. In 2006, the Department of Labor blessed the funds as one of three 401(k) qualified default investment alternatives (QDIAs). Plan sponsors are liable for prudently choosing and monitoring QDIAs, and for communicating their risks to participants who are defaulted into them, but they avoid liability for investment results.
One Size Doesn't Fit All
In addition to this regulatory stamp of approval, target-date funds offer an appealing solution to an intractable problem: how to turn the average employee into a discerning investor. Most employees have a limited attention span for investment education. "We have about an hour to explain the importance of saving, why the 401(k) plan is the best way to do that, and basic investing concepts: what a stock is, what a mutual fund is," says Thad Hamilton, vice president of TRI-AD, a 401(k) administrator and record-keeper. "By the time you get to the difference between large-cap value and small-cap growth, you've lost them. A target-date fund with a good glide path makes it easy: 'You're retiring in 2020? Here's a 2020 fund.'"
Not surprisingly, a professional manager often makes better allocation and rebalancing decisions than a participant would. A Vanguard Group study of more than 1,300 401(k) plans compared risk-taking between investors in target-date funds and those not investing in such funds. The analysis of non-target-date investors found large concentrations of participants with either extremely conservative or extremely aggressive portfolios. The target-date investors had a range of portfolios that were consistent with long-term investment principles. "Target-date funds eliminate the extremes, improve diversification, and add automatic rebalancing," says Stephen P. Utkus, a principal at Vanguard Center for Retirement Research.
But as their detractors point out, they are one-size-fits-all: everyone who chooses the same retirement year gets the same portfolio. "That's a big reason we're not comfortable with target-date funds," says Tom Dunn, CFO of Southwest Power Pool, a regional transmission organization in the electric utility industry. Instead, the company's 401(k) opted for a slate of traditional funds, which its investment adviser has used to create five customized portfolios based on risk preferences. "If you're a 55-year-old who has zero dollars saved for retirement, I don't think you want the same portfolio as a 55-year-old who has $2 million," says Dunn.
A more serious flaw is that regardless of investors' age, there's no consensus on what constitutes a good portfolio mix or glide path. A glide path doesn't lend itself to benchmarking, explains Idzorek. There is no standard, because what's best really depends on the individual investor's circumstances and preferences. Nor is there any regulatory guidance. "There are absolutely no regulations regarding the composition and marketing of target-date funds," says Sen. Herb Kohl (D–Wis.). That may soon change. Kohl has asked the Labor Department and the Securities and Exchange Commission to address the matter.
Meanwhile, the popularity of target-date funds provides plenty of incentive for investment firms to continue to refine, and more clearly define, their offerings. No doubt there is room for improvement. Companies can help drive some improvements by asking more and harder questions about how these funds are designed (and why), and by making sure that the information provided to employees about such funds doesn't stress their simplicity to the point where inherent risks go unacknowledged.
Lynn Brenner is a freelance writer based in New York City.