In a nutshell

Since target date funds (TDFs) became available as a permissible default or an option for 401(k) accounts, their popularity has been exploding, with predictions that within a decade 50% of 401(k) funds will be in TDFs.

But some are raising valid concerns about these supposed “one decision” “low/no maintenance” funds. Given the huge variability in the returns of TDFs with the same target dates, questions arise about their and suitability as a default 401(k) investment vehicle or as a retirement investment vehicle in general.

The collateral damage of the simplicity of TDFs is the potential complexity created elsewhere due to: glide-path variability, cost, fit in overall portfolio, risk tolerance variability among individuals and over time, and tax efficiency.

Potential solutions: (1) define the 401(k) default TDF a ‘to’ target date fund, (2) other useful 401(k) options: ‘through’ target-date fund, ultra-low cost index funds to build custom asset allocation, fixed allocation balanced fund, and decumulation with systematic withdrawal plans, and (3) employer supplied independent financial education, guidance and advice.

Most important that if you have defaulted to or explicitly selected a TDF implementation for your 401(k), you should seriously consider the impact of the surrounding problems/complexities associated with the use of a simple TDF. (I prefer to mix my own to allow me to keep tax-inefficient assets in tax sheltered/deferred accounts while more tax efficient assets in taxable accounts.)

Problems

While TDFs sound deceptively simple, their very simplicity might in fact be the reason for complexities and considerations associated with their use:

-Glide-path: varies among managers, often dynamic even with a manager, ‘to’ or ‘through’ target-date, appropriate for your requirements?

-Glide-path implementation with: active vs. passive, stocks and bonds with/without alternatives, TDF ingredients and proportions of assets specified?

-Fit: how to fit TDF in overall target portfolio asset allocation over time

-Cost: TDF management fees and the all-in 401(k) costs?

-Risk tolerance: variability in risk tolerance among investors or for that matter potential variability of risk tolerance with age ‘to’ or ‘through’ target-date for an individual; is the default TDF applicable to your needs or you’re better served by a fixed asset allocation?

-Tax efficiency: how does the TDF affect the tax efficiency of your portfolio?

-Does the simplicity of the TDF create complexity in the rest of your portfolio?

Potential solutions

While there is not one right answer applicable in all situations, but potential solutions include:

-Standardized glide-path for default TDFs: for example 80-100% equity up to 10 years pre-retirement, 0-20% equity at-/post-retirement, and linear reduction of equity allocation during the 10 years of transition (i.e. a ‘to’ target-date glide-path)

-Other desirable 401(k) options: (1) ’through’ target-date glide-path, (2) ultra-low cost index funds to enable construction of custom allocation, (3) 50:50 balanced portfolio or (4) Financial Engines target-date allocation 80% bonds and 20% equity, 15% of the bonds reserved for age 85 to be converted to annuity at the time, while the balance (65% bond and 20 equity) decumulated via a systematic withdrawal plan over 20 years.

-Employer/Sponsor to offer qualified 3^rd party sourced education and/or guidance and/or advice

Most important that if you have defaulted to or explicitly selected a TDF implementation for your 401(k), you should seriously consider the impact of the surrounding problems/complexities associated with the use of a simple TDF. (I prefer to mix my own to allow me to keep tax-inefficient assets in tax sheltered/deferred accounts while more tax efficient assets in taxable accounts.)

Background

Target-Date funds are conceptually very simple, and sort of obvious. They are based on the assumption that as you age in general, but as you approach retirement in particular, you should be reducing you portfolio risk by reducing your allocation to equities (or risky assets). Target-Date funds (TDFs) are supposed to be essentially “one decision” funds with “no/low maintenance requirement”; you just choose your retirement age and you’re good to go. Well, almost…

TDFs are primarily characterized by their “glide path” which describes how the asset allocation (e.g. mix of fixed income and equities) changes as you approach your planned retirement date (and beyond). The popularity of TDFs has been increasing dramatically, especially since they became a permitted default or option for many 401(k) plans; the forecast now is that, if current trends continue, within ten years 50% of all the 401(k) moneys will be invested in TDFs.

To get a sense of the growing acceptance of TDFs as a de-facto default retirement investment vehicle we’ll look first at some of the recent weeks’ publications on TDFs. There were at least two articles noted in the WSJ, one in the NYT, as well as an OECD report endorsing Target-Date Funds as a DC pension plan default. The problem is that choosing or defaulting to a TDF option in one’s 401(k) does not fully determine what you invested in, since not all TDF are created equal!

In Karen Damato’s WSJ article “One size won’t fit all” she starts by looking at the dramatic differences in the performance of TDFs. Best/worst one year performance, for example, in 2010 and 2040 TDFs was 4.08%/-2.56% and 12.86%/-6.31%. This very large performance variability is readily explained by the level of stock exposure and whether alternatives (e.g. commodities) are used in the allocation.

In Michael Pollock’s WSJ piece “One target, but many ways to hit it” he writes that “with target date funds the targets never change. But strategies for hitting those targets are all over the place…asset-management industry continues to debate how best to design the funds for their central mission: generating enough asset growth, even through stretches of poor stock-market performance, to tide over investors through their entire lives.” Message is the same but glide paths are all over the place (various glide-paths both pre- and post- retirement) and some TDFs are adding ‘alternatives’ (e.g. commodities, REITs). Some observers note that “there is (not) one right solution- the various approaches all have intellectual validity”, but the result is that it is very difficult to objectively compare TDF performance. Some funds even “adopted a tactical-asset allocation approach that can dramatically change fund glide paths temporarily, when quantitative and fundamental analysis point to heightened equity risk.” (Wow, this may sound great, except if you have other assets as well and you would like to maintain a defined overall exposure to risky assets.)

In NYT’s“Target-date funds not equally safe” Ron Lieber looks at the wide differences in risk aimed at a specific age group contained in target-date funds; he provides examples of TDFs aimed at 63 year olds which range between 63% stock to 63% bond allocation! The difference in these funds are a result of honest philosophical differences between employers and/or fund managers whether, at one extreme, the focus should be on sufficient assets with adequate buying power having to last possibly 30+ years, all the way to worrying about a big market drop just before retirement which would prevent retiree from taking commuted value to meet some expected expenditure(s) or from buying an annuity with a specified retirement income level.

And the TDF party is getting so hot that everyone wants a piece of the action. According to InvestmentNews’  “J.P. Morgan set to kick down the 401(k) door for ETFs” J.P. Morgan are getting on board with “plans to launch a series of target date funds that blend active and passive strategies”. They plan to ““use ETFs for asset classes…widely regarded as efficient markets”. That means U.S. large-cap equities — which will represent up to 40% of the funds — are the most likely asset class to get the passive treatment.” The passive/active blend of funds will have expense ratios of 0.85% compared to their all active fund of 0.99%. (Of course 0.85% is far from cheap when you can buy Vanguard’s TDFs for <0.2%, or you can bake your own for even a little less (though in Vanguard’s case by not much) for cost or glide-path considerations; of course you’ll have to be prepared to do a little asset allocation and rebalancing work yourself.)

The OECD pension report issued in June 2012 entitled “OECD Pensions Outlook 2012” recommended default for DC plans to have an asset allocation glide-path of (high) fixed equity allocation until 10 years before retirement, but then a rapid reduction in risky assets to zero (!) on p.180.  I also got a note from Ron Surz, following my comments on the OECD report a few weeks ago, who advocates a very similar default 401(k) glide-path for target date funds-see his Safe Landing Glide Path .  If you think about it a little, this actually makes good sense: a default of constant high risk to age 55 (e.g. 10 years pre-retirement) and then reduce risk to a very low level approaching retirement. This would allow better predictability for those individuals who would like to take the cash value and/or annuitize, but would still allow those who have more risk tolerance the option to add risk elsewhere in their overall portfolios and/or for some level of inflation protection.

To TDF or not to TDF

But there is no unanimity that TDFs (i.e. glide-paths of decreasing risk with age) are the right answer as 401(k) defaults in general or even as options for specific individuals. After all, if you consider that risk tolerance is a very individual matter, and individuals typically have other assets and/or income sources than their 401(k)s, then you could make an intellectually compelling argument that you should not use TDFs at all, especially if you factor in (as you must) cost considerations, as I discuss in one of my three 2008 blogs on TDFs entitledAre “target-date” funds or age-independent “fixed-asset allocation” right for you? . It is not just, that age and/or years from retirement are not the only risk tolerance drivers, but the non-standardized or even dynamic asset allocation of the glide-path makes it difficult to maintain the overall portfolio asset allocation consistent with and corresponding to the one’s risk tolerance. Furthermore, some might argue that those who don’t plan to annuitize their 401(k) assets at retirement but perhaps use some systematic withdrawal approach, have a much longer horizon, and zero equity allocation at retirement might be unsuitable; this is the argument between those who say that the asset allocation at the target-date of a TDF will be different whether it is intended to be a ‘to’ or a ‘through’ target-date fund. There can honest differences in professional opinion as to what’s appropriate in each case.

In-between the two extremes (0% or 100% equities), but challenging an age-dependent asset allocations are: economics professor emeritus and Nobel laureate Paul Samuelson, and professional investor, author and educator Charles D. Ellis.

In a CFA Magazine article entitled “Canny portfolios” (available only to CFA Institute members) Paul Samuelson states that “I warn against the popular fable that your father at age 50 definitely needs a different portfolio composition than you do at 30. Allegedly, when you reach 50, faced then with fewer investment periods ahead before retirement, you should transform holding into “safer stuff.” The brokerage industry is infatuated with “Life Cycle Target Funds,” tailored differently for those who will retire in 2020 rather than in 2040.” He goes on to say that both the young and old in developed countries (U.S., E.U. or Japan- and I assume he would include Canada) “could aim for about the same passive diversified-index portfolios”. Over time, as the developing world “level of affluence” increases, there will be a reduction of the U.S. securities (stocks and bonds) component of the portfolio “from 85%, to 75%, etc”.

Charles Ellis in his book “Winning the Loser’s Game” (this book is a must read!) comes down unequivocally against arbitrarily reducing your equity content with age, because “your investing horizon is far longer than your living horizon” (because otherwise you are forced to take age-driven taxable profits, penalizing beneficiaries of your estate -i.e. children, grandchildren and charities- who will almost certainly outlive you; this is even more true in the US than Canada, since in the US a stock portfolio (often) passes to estate beneficiaries not just without tax at death but the tax basis is stepped up to market value at death in the hands of beneficiaries.). He then suggests his two most important decision rules: “(1) any funds that will stay invested for 10 years or longer should be in stocks and (2) any funds that will be invested for less than two to three years should be in “cash” or money market instruments”.

Schleef and Eisinger in “Hitting or missing the retirement target: comparing contribution and asset allocation schemes of simulated portfolios” “conclude that ‘life-cycle funds’ (also called target-date funds) that reduce equity allocation over time fail to increase the likelihood of reaching a targeted portfolio value compared with fixed asset allocation models” (80:20 or 70:30).

Others have suggested that, even though TDFs qualify under ERISA as a QDIA (Qualified Default Investment Alternative) which offers 401(k) fiduciaries some level of “safe harbour”, some target date funds with high equity allocations are motivated by the higher fees that are typically associated with equity funds, due to a natural conflict of interest between the fund manager (collector of fees) and 401(k) investor

So there you have it! You could call these perspectives the ‘target-date funds are a passing fad’ perspectives. These experts effectively don’t believe in principles underlying target-date funds.

Complexities of TDF simplicity

So while the use of TDFs in 401(k) plans is experiencing explosive growth, the TDFs’ implicit simplicity, low/no maintenance yet high variability among managers (and in case of dynamic glide-path, even for the same manager) may turn management of one’s overall portfolio into a can of worms:

-How do you maintain a known/specified overall portfolio assets allocation at any point in time if you do not know the glide-path of your (default) TDF?

-Even when you know the exact glide-path committed by the TDF manager, the “one-decision” “low/no maintenance” TDF glide-path may force continuous adjustment to the rest of your portfolio in order to achieve desired asset allocation (i.e. risk tolerance); so low/no maintenance in the 401(k)/TDF part of the portfolio just created a very high maintenance in the rest of the portfolio.

-Do you understand your TDF manager’s strategy and whether the selected ‘glide-path’ is intended to operate ‘to’ retirement (e.g. planning to convert to annuity or cash value) or ‘through’ retirement (e.g. an asset allocation suitable for a systematic withdrawal plan)?

-Do you even know the complete set of ingredients (cash, stock, bonds, alternatives, active or passive, domestic or international, etc) that your TDF manager is using to construct the fund?

-Do you understand the total cost of your TDF (and all-in cost of your 401(k) account) as well as the impact of these costs over a 40-60 year accumulation/decumulation timeframe?

-Are you convinced that an age-dependent asset allocation (glide-path) is appropriate for your personal needs? Not all individuals of a given age have the same risk tolerance nor for that matter do all individuals have decreasing risk tolerance with age.

-For tax efficiency one typically tries to keep highly taxed interest generating fixed income assets in a tax sheltered account and keep significantly lower taxed risky assets (e.g. equities) generating dividends and capital gains in taxable accounts. How do you manage such tax considerations when you have selected a TDF for your 401(k) and all or a significant part of your assets are in a tax-deferred account? If you think that tax considerations are unimportant, you might wish to read “When taxes collide with your asset allocation”.

The bottom line

There is no one correct answer for everyone. TDFs as 401(k) defaults or options (as currently constituted) may in fact be at least sub-optimal and possibly unsuitable for just about everyone using them. Here are some thoughts about making TDFs, when used as 401(k) defaults or even options, better/safer for affected individuals:

-The TDF glide-path should be explicitly specified and perhaps even standardized, so overall portfolio risk can be understood and managed

-At target-date when the TDF is the default (e.g. with auto-enrolment) the equity allocation should be low or zero to maximize flexibility and minimize risk for most participants; this would be considered a ‘to’ target-date fund which accommodates: those who want to annuitize immediately (or in stages), those who might want tax-inefficient assets in the 401(k), those who have most of their assets in 401(k) accounts and are concerned about a massive market swoon around retirement, those who plan to use some systematic withdrawal strategy to age 85 (as discussed above)

– Employer/Sponsors should also consider offering: (1) another TDF(s) with different glide-path for those whose investment horizon is significantly beyond the target-date; this is a ‘trough’ target-date fund, and (2) ultra-low cost index funds for those who wish to create their own asset allocation (or glide-path) within the 401(k) as a stand-alone or part of an overall portfolio, (3) fund with a fixed allocation for example something as simple as a balanced fund with 50:50 stock/bond allocation and/or (4) Financial Engines was quoted to operate an approach whereby one’s 401(k) is allocated 80% bonds and 20% stocks (with 85% of the total, 65% bonds and 20% stocks, are decumulated between ages 65-84, and the rest can be converted to an annuity if alive at 85); this approach appears to make allowance for both tax consideration with 401(k) being heavily loaded with tax-inefficient assets (likely leaving more tax-efficient assets in taxable accounts) and longevity considerations by leaving 15% of the 401(k) to be potentially converted to an annuity at 85.

-Employer/Sponsor should offer with the 401(k), if not advice then at least guidance and if not guidance then at least financial education (e.g. many employers/sponsors make bulk arrangements for their 401(k) participants in programs such as that offered by Financial Engines which in addition to asset allocation services, also provides tools and personalized advise to participants; Vanguard also offers at no charge some of Financial Engines’ services to those with invested assets above some threshold value.

Most important that if you have defaulted to or explicitly selected a TDF implementation for your 401(k), you should seriously consider the impact of the surrounding problems/complexities associated with the use of a simple TDF. (I prefer to mix my own to allow me to keep tax-inefficient assets in tax sheltered/deferred accounts while more tax efficient assets in taxable accounts.)