Timing is everything.

This piece on target-date funds was submitted on

January 26, 2009 and accepted for publication by a leading online site.
Unfortunately, it wasn’t published in a timely fashion, and after the Wall
Street Journal did an article on the funds in early March, it was determined
that this would be redundant. This is the (unedited) second version I submitted.

Way Off Target

By Tom Brakke, CFA

Target-date mutual funds have been one of the hottest investment products of
the last decade. Also commonly called “lifecycle” funds, they are sold as a
convenient way for clients to meet their financial goals for retirement—one
decision by the client (buy the fund) and the investment manager does the rest.
The mix of assets migrates along a predetermined “glide path” that reduces the
amount of risky assets over time.

The basic theory makes sense: Investors should take higher risks when they are
younger—when there is time to rebound from any bad years in the market—and
pull in their horns as they approach retirement age. As a result, target-date funds
are gaining wide use within defined contribution plans such as 401(k)s and
403(b)s, and are increasingly popular in IRAs as well.

Introduced just fifteen years ago, the funds are still a small part of most plans and
represented only 3% of the total assets in defined contribution plans as of June
30. But the growth of late has been stunning, with assets increasing more than
60% a year for the five years through 2007. Last year’s market decline will put a
dent in that growth rate, but the target-date funds are positioned to thrive going
forward.

Reeling from a decline in business in other areas, mutual fund companies will
redouble their efforts to promote target-date funds, and the wind will be at their
back due to structural changes at many defined contribution plans. Historically,
participants in those plans have tended to repeat a few common investment
mistakes, including borrowing against their funds in non-emergency situations,
taking on too much risk in their company’s stock, and keeping a large portion of
their assets in low-yielding stable value funds (which are now under scrutiny for
an entirely different reason).
Many plan administrators have looked for ways to mitigate those problems, and
one alternative, using target-date funds as default options within the plans, was
sanctioned by the federal government in the Pension Protection Act of 2006.
Many employers have since adopted that approach; their tacit approval and the
tendency for most people to stick with the default options will lead to strong cash
flows into the funds going forward.

Is that a good thing? While they are based on some sound investment
principles, target-date funds are too simple in construction and ignore important
market realities and the true needs of individual investors.

As with much financial planning offered these days, the funds are structured
based upon questionable assumptions about asset classes and how they
perform over time. Historical returns, the variability of those returns, and the
correlations among the returns of different types of assets are used in asset
allocation models as if they were facts of nature. In actuality, those inputs
migrate over time, and the strong returns on risky assets in the nineties
contributed to a complacency about market outcomes that has finally been
shattered.

One set of target-date funds that have gotten some attention are those that have
2010 as the reference date, since many on the verge of retirement saw large
losses in their account balances (with some drops exceeding 30%) during 2008.
Many younger investors were equally unprepared for the breathtaking declines in
their account balances.

There is no “right” answer to the question of whether a particular fund is

structured too aggressively, because the owners of that fund are not monolithic in
their needs. This is contrary to the simplistic equations often given by marketers
and financial advisors as to what percentage to hold in equities. They typically
give answers based on “100 minus your age” or even “120 minus your age.” The
formulaic approach of most target-date funds is just one step up from that, and
just as wrong.

The main flaw is that deciding that someone should have X% in equities and
other risky assets without regard to the valuation of those assets ignores an
important relationship: The higher stocks are valued at any point in time, the
higher the probability that they will perform worse than their historical average
return.

In addition, the suitability of a product for a specific client is the bedrock of sound
financial advice, yet target-date funds and their purveyors treat suitability as one-
dimensional, with time to retirement the driver of the risks that are assumed. The
passage of time is an important factor, but advice and investments also should
evolve as markets and personal circumstances change. There is no substitute
for the recalibration of an investment plan year by year, not in accordance with
some predetermined schedule, but in response to a careful assessment of the
risk and return available in the markets, the impact of various possible outcomes
on real spending plans for the future, and the implications of other personal
developments.

The greatest beneficiaries of the trend toward the use of these one-stop
investment vehicles are the fund sponsors themselves. The assets are “sticky,”
destined to grow over time, and usually sport fees that are higher than they
should be. Because they get paid on assets under management, the fund
companies have suffered a decline in income from these products with the fall in
the markets, but longer term the target-date funds are a better deal for them than
for the investors.

Given the growth in the business, firms will be rolling out new variants on the
target-date fund concept, and some will include features that are better than
those generally available now. Already there are some offerings that allow for
choosing different risk levels for each target date. Some will get less
programmed and more responsive to changing markets by moving away from
fixed glide paths and toward more variable asset allocations. And new fund
structures may become more integrated with the future spending plans of their
owners by incorporating guaranteed balances or payments.

Unfortunately, such improvements will not change the basic shortcomings of

target-date funds. By their nature they feature standardized designs and
generalized investment advice, yet individuals have specialized needs. The
investors in a particular fund may all own the same portfolio, but they have
different tolerances for risk and significantly different exposures to the economic
disruptions that will affect them apart from their investment portfolios. A person
investing in target-date funds outside of a defined contribution plan might be able
to investigate the alternatives and find one that fits their situation (at least for
now), but those within plans are usually stuck with one choice and increasingly
find the initial selection made by default based upon their age.

Their chances of meeting their real targets for the future may be lower than they
think, creating a problem for them and for the industry now pushing products that
promise more than they are likely to deliver.