Target-Date Funds May Not be Best DC Option: Enormously Popular Category Has Yet to be Perfected
July 7, 2008
Despite their tremendous growing popularity for their set-it-and-forget it convenience of automatically reallocating equity-to-fixed income ratios every year for 401(k) investors, target-date mutual funds may not be the best option for defined contribution plans.
Thanks to the Pension Protection Act of 2006, target-date funds have become a default option in many 401(k) and 403(b) defined contribution plans. However, analysts stress that target-date funds, which transition investments from growth to income as an investor nears retirement, are not all alike. So an employee could get stuck with a fund that is inappropriate for his or her tolerance for risk and cash flow needs.
There are 300 target-date funds with assets of almost $200 billion, according to the Investment Company Institute. Not all are alike. The majority have not even been around for three years, according to Morningstar, so they have no track records.
"There are a lot of new products available, so it is difficult to evaluate them," said Chris Lyon, a partner with the employee benefits investment consulting firm of Rocaton of Norwalk, Conn. "Unfortunately, plan participants have no option when it comes to selecting the investment company that runs the target-date funds in the plan."
So, why are some experts naysaying one of the most popular fund categories since the bull market of the 1990s? The biggest problem, as they see it, is no two target-date funds are built alike. The asset allocations differ as well as the glide paths, according to Lyon. As a result, some funds are more aggressive in later years when an individual nears retirement. Others are not aggressive enough during the accumulation stage.
Morningstar research shows, for example, the Franklin Templeton 2025 Retirement Fund gained 9% in 2007, while the Putnam Retirement Ready 2025 Fund gained just 1.5%. The reason for the difference: Franklin had a much larger weighting in mid-cap stocks than Putnam.
There are also considerable differences in fees, investment styles and the methods used to tactically allocate assets during the glide path.
"You see the biggest discrepancies in short-date target funds," said Joe Nagengast, president of Target Date Analytics of Marina del Rey, Calif. "The funds claim they have the same purpose-to provide stability for investors. But some funds, like those from AllianceBernstein and T. Rowe Price, have over 60% in stocks when they are just two years away from their target dates. This could be too aggressive for many people nearing retirement."
Nagengast added that there aren't big disparities in asset-allocation mixes of longer-term target date funds in the 2030 to 2050 range. It is only when they near their target dates that the stock and bond allocations can significantly differ.
Over the long term, Nagengast believes that all target-date actively managed funds will underperform their benchmarks due to fund expenses.
He added that that nearly 90% of the assets in target-date fund assets are held by Fidelity Investments, T. Rowe Price and Vanguard-three giants that are well known for taking widely different approaches to portfolio management.
"My criticism is couched with the understanding that most people are better off in a target-date fund [in their 401(k) or IRA]," he says. "It is a better solution than doing it on their own." That said, Nagengast believes a better version of the invention needs to be invented.
Lyon said that as the target fund market matures, defined contribution plan participants will have better target fund options. In addition, he believes insurance companies tack on a lifetime guaranteed withdrawal benefit to the funds. As a result, retirees will be able to take 5% to 6% systematic withdrawals from their target-date funds. When the account draws down to zero, an annuity will kick in and continue paying for as long as they live.
As companies evaluate the withdrawal patterns of their employees, they can have target-date funds developed to fit a company's needs.
Many plan sponsors want investment companies to customize them for their plans by setting up "Collective Investment Trusts." With tailor-made Collective Investment Trusts, investment companies can lower costs and offer a wider range of alternative investments in real estate, REITs and emerging market securities. These newly formed collective trusts use more sophisticated asset-allocation and glide path strategies.
There is no free lunch with target-date funds. Financial research shows employees that hire an experienced financial adviser to help manage a 401(k) may be better off insuring that the risk level of the mutual fund matches a client's tolerance for risk based on his or her investment time horizon.
An April 2008 working paper by Francisco J. Gomes, a finance professor with the London School of Business, found that target-date or lifecycle funds that do not match the risk tolerance and investment horizon of investors may not deliver as much as a retiree expects. The paper, "Optimal Lifecycle with Flexible Labor Supply: A Welfare Analysis of Lifecycle Investing," is available at the National Bureau of Economic Research at www.nber.org/papers/w13.
Other research, published in the 2007 Financial Services Review by Harold J. Schleff, economics professor at Lewis & Clark College, found that investors would do just as well investing regularly and passively with a mix of stocks and bonds during the accumulation stage.
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