Target Date Funds Need Work

Target date funds performed worse during the crisis because they were not diversified enough

The collapse of the financial markets has sounded a strong wake-up call for target date funds. While these funds did help to mitigate the impact of extreme volatility for those who invested in them, many still believe that the losses they sustained were nevertheless far greater than they should have been. Since more and more retirement plans are likely to offer target date funds as default options going forward, they need to be fixed if they are to live up to their name and their promise.

"Target date funds are a great idea but they need substantial improvement," says Ron Surz, president and CEO of San Clemente, California-based PPCA Inc., whose firm has developed benchmark indexes for target date funds. "People are saying that this market collapse is just a fluke, but even so, those who invested in target date funds should not have lost so much."

Surz believes target date funds performed far worse than expected during the worst of the crisis because they were not diversified enough; their asset selection was poor because they were too "inbred" and their glide paths--which suppose that an investor will remain in a fund even beyond its maturity date--have been poor. These characteristics have resulted in significant losses to most 2010 and 2015 funds--vehicles that should not have fallen as much as they did, Surz maintains. According to PPCA figures, investors in near-term, current, and 2010 funds have lost 12% and 25%, respectively, in just the past year, and those in longer-dated funds have lost more than 35%, thereby underperforming the firm's benchmarks significantly.

As they now stand, target date funds are also unable to address the numerous complexities that come about in the distribution phase of a person's life.

"Although it seems that everything crashed together, diversification actually did help in 2008," Surz says. "Target date funds need to diversify beyond just stocks and bonds. The inbreeding comes about because fund companies are using only homegrown products and not offering an open architecture and the glide path needs to end at the target date."

Experts like Andrew Scherer, managing director at Van Kampen Investments in Oakbrook Terrace, Illinois, also believe that target date funds need to evolve more, especially given the current economic and financial context. It is very important for a plan sponsor with a fiduciary responsibility to be mindful of the construction of the target date fund, Scherer says, "as in our view, some have a better asset allocation methodology than others." Van Kampen's target maturity fund, for instance, is different from others in that the asset allocation process is designed to ensure that a 401(k) participant has the necessary income in retirement to maintain their lifestyle. "This is an important consideration and because of this approach, we feel we have had a more appropriate allocation to equities than others," Scherer says.

Nevertheless--and notwithstanding the serious decline in the market--investors have by and large stuck with their investments, Scherer says, and target date funds have played a significant role here, as investors have maintained their investments and not responded to the markets in a knee-jerk fashion, he says.

According to a recent study on target date funds undertaken by Valley Forge, Pennsylvania-based Vanguard, these vehicles have helped eliminate extremes--either too risky or too conservative--in investor behavior. The study showed that the participants who did not invest in target date funds tended to exhibit greater extremes in their equity holdings. Thirty percent held risky, all-equity portfolios, while 16% held highly conservative, zero-equity portfolios. In contrast, the stock exposure of target date fund investors ranged generally from 40% to 90%, depending on their age and time to retirement.

This beneficial effect of eliminating extreme allocations extended even to "mixed investors"--those who combined target-date funds with other plan investment options, Vanguard said. The study examined the characteristics of "pure" and "mixed" target-fund investors and found some differences between them, but the reduction in extreme allocations extended to both.

The study also found that investors in target date funds have a markedly different pattern of equity exposure by age compared with investors not in these funds. For non-target-date investors in the study, allocations to stocks declined by less than 10 percentage points between the ages of 25 and 65. The equity allocations of target-date investors, on the other hand, declined more than 40 percentage points over the same age range.

Of course, not all target date funds are the same, so determining whether an investor lost more or less in a target date fund than in a mutual fund would depend on individual products, says Lynette DeWitt, director of sub-advisory at Boston-based Financial Research Company. The bottom line is that target date funds have performed relative to their equity asset allocation, she says, so the key is to look very closely at equity allocations and make sure they're aligned with what an investor is looking for.

DeWitt also believes that target-date funds need to be enhanced further and become more nuanced in order to be more effective.

"I keep advising fund manufacturers to label their funds as they are, say clearly that they are conservative, aggressive and so on," she says. "We definitely need these products to have more nuances, but overall, the important thing is for investors to not be myopic and to keep their long-term strategy in mind. This calls for constant interaction with an advisor, and I'd say that in this market, advisors have more of a place--not just because of the growing interest in target-date funds but also in helping their clients pick the right ones that fit in with a client's overall strategy and goal."

Advisors are also keen to see more fine-tuning in the target date space, and many are interested in seeing multi-managed solutions come to the fore, Scherer says. Thus far, only 15% of target date funds utilize this approach, but given that by 2015 target maturity funds will represent as much as 35% to 50% of total defined contribution assets, this is an important feature that has to be implemented, he says. Educating advisors about the Pension Protection Act and about how target-date funds can meet the needs it specifies to fit within this new framework is also very important.

Reprints Discuss this story
This is where the comments go.