From the November 2009 issue of Investment Advisor • Subscribe!

November 1, 2009

Danger & Opportunity: Crafting a Better Target Date Fund

Putnam Investments is first to mix absolute return strategies with traditional mutual funds

Striving to help investors pull in higher retirement incomes, Putnam Investments has revamped its existing line of target date funds by integrating target absolute return strategies with traditional mutual funds.

By combining target absolute return and traditional mutual fund strategies into Putnam's RetirementReady target date fund suite, Putnam says that "the funds will seek to mitigate market volatility and create a more stable sequencing of investment returns."

Putnam and others in the fund industry have been engaged in the debate--along with the Securities and Exchange Commission and Department of Labor--about whether target date funds are creating the amount of income pre-retiree and retirees' need--particularly since many of these funds that were heavily weighted in equities saw a significant downturn last year for those nearing retirement. Using its 10 years of experience in offering absolute return strategies to institutional and high-net-worth investors, Putnam has found that, "if you integrate the absolute return with a relative return [mutual fund strategy], you can get just as good a return [as using equities], sometimes better, and more downside protection and much less volatility," says Robert Reynolds, president and CEO of Putnam Investments.

In January, Putnam launched the industry's first suite of target absolute return mutual funds that seek annualized total returns of 1%, 3%, 5%, or 7% above inflation as measured by Treasury bills over a period of three years or more. It is that suite of funds that will be woven into Putnam's 10 RetirementReady target date funds' glidepaths, with a greater allocation to absolute return strategies as the investor gets closer to retirement. "The closer you get to retirement the more allocations to absolute return because again, you get more predictable returns and less volatility," says Reynolds. Allocating more to absolute return strategies as a person nears retirement "really protects the investor from the type of year we had last year. The real risk in these target date funds is that you have a big downturn right before someone retires and therefore their nest egg is not what they thought it would be; they either have to work longer or have lower sites for what they can spend in retirement."

Jon Goldstein, a Putnam spokesman, says that since being launched in January, the absolute return funds have "been tracking extraordinarily well." Through August 31, 2009, the year-to-date return for the Putnam Absolute Return 100 Fund is 2.3%; the Absolute Return 300 Fund's return is 4.7%; the Absolute Return 500 Fund's return is at 6%; and the Absolute Return 700 Fund's return is at 9%.

Putnam also notes that it shifted its RetirementReady Funds traditional fund-of-funds approach to a "more comprehensive management style, with Putnam's Global Asset Allocation team responsible for all aspects of the funds' management, from overall diversification strategy and mix of investments, down to individual security selection." Putnam says that the absolute return strategies employed in the RetirementReady Funds enable "portfolio managers to invest anywhere in the world and move dynamically to be positioned in sectors, asset classes, or geographies they see as likely to produce positive returns."

Laura Lutton, editorial director in the Fund Research Group at Morningstar, says that such manager freedom in absolute return strategies raises the question of managements' "ability to stay on the right side of things over the long-term." But Reynolds says that giving the managers a "target return," for instance, the Absolute Return 700 Fund seeking 7% return over inflation, "brings in the risk profile of that portfolio." This way, he says, "you don't have managers swinging for the fences in order to get a big performance fee." That said, Lutton says she still wishes there was more transparency about "where the managers have been and where they have accessed certain asset classes."

Washington Bureau Chief Melanie Waddell spoke with Reynolds in late September about Putnam's revamped target date funds as well as the investing environment in general.

Can you talk about Putnam's new strategy of integrating the absolute-return strategy into its RetirementReady target date funds? Is this strategy the answer for target date funds, getting them to show better performance, considering the losses they incurred last year?

We've been doing absolute return for over a decade for institutional clients and earlier this year we came out with a family of [target absolute return mutual funds] to allow the advisor/client a choice of return they were looking for and the commensurate risk with that. Then we started ....looking at where does [target absolute return mutual funds] make sense as far as a fit in a total portfolio. At the same time the whole debate was raging, which we were participating in, around target date funds and whether they are really doing what they should be doing for investors. Basically the work we did on absolute return funds [found] they do provide returns with a lot less volatility....Again looking at these and trying to grapple with the real challenge that target date funds have, and the challenge is as you get close to retirement, what amount of your portfolio should be in equities? And that's where the debate was. Some firms had 80% equity in 2010 funds and then you had firms like us that were less than 30% in equities. We do think there is a challenge to these funds as people get close to retirement that they don't take a major hit on their nest egg.

What do you say to critics who say integrating absolute return with traditional mutual funds is an unproven strategy?

We've been doing absolute return on the institutional side for over a decade. I think the absolute return funds have been used for many, many years by large institutions and high-net-worth individuals and that is the whole start of hedge funds. That rather than chasing a benchmark like the S&P 500 or Russell, you had a fund that tried to invest every year to generate a positive return in some excess return over inflation. That's where the whole concept [of a hedge fund] came from. And I think over time what happened as the way the manager was rewarded, the greater the performance the greater the rewards, so it became an imbalance as to risk and what the manager was trying to do. By targeting returns, and we think these are very reasonable returns--700 over T-bills, 500, 300, and 100--that you lower the risk posture of these underlying funds by targeting these different returns.

What do you say to the management side, where with absolute return funds managers can go where they see the opportunity? Wouldn't investors be wary of whether the manager is finding the right investments?

When you target the return--say I want to be 700 over Treasuries--it really brings in the risk profile of that portfolio.

So "targeting the return" is the key here. That's different from what institutional investors do?

Correct. [By targeting the return] you don't have managers swinging for the fences in order to get a big performance fee.

Why is Putnam the first on this absolute return bandwagon?

I think people are looking at it because they are looking at ways to diversify target date funds and ways to lower risk. I think there are two major risks in these funds when people reach retirement: one is the nest egg, have they earned enough? The other one is longevity risk. The smaller your nest egg, the harder it is to hit the longevity risk and hit your income targets for retirement. That's why we think it's so important to have protection, so to speak, as people get close to retirement so you're not faced with a down year right before retirement. It's interesting when you look at the sequence of returns, in other words over a 10-year period you can have an average return...but if your down period is in the later years, it has a dramatic impact on your nest egg.

Putnam has recently changed its manager compensation strategy?

Our goal is to be in the top quartile of a peer group over a rolling three-year average. So at the beginning of the year, the manager knows his bonus target. In order to get the bonus target, he's got to be in the top quartile over a rolling three years. If he is up in the top quartile, he can get a larger bonus, but if he's a median manager, he only gets half of his bonus. If he falls into the bottom quartile, he does not get a bonus. We feel this puts the manager on the same side of the table as the shareholder because you put money in a fund because you expect the fund to perform. We think it's a great structure and people are excited about it and it sets us up to generate the types of returns that everyone should expect from us.

Where do you think the SEC is going to come down on target date funds?

I think the SEC is going to set up some type of limits as to how much equity exposure you can have, especially as the fund gets close to retirement. A lot of people have been against this, but the SEC has set parameters for all types of funds. A balanced fund, for instance, has to be at least 30% in fixed income; an international fund has to have at least 80% non-U.S. stocks--so there are requirements. I can see the SEC saying that any fund that is five years from retirement can't be more than 50% in equities. I do think that's a resolution to the issue; and you can take a step back from that and say rather than set a limit just have disclosure so someone knows exactly what they are buying in all 2010 funds, all 2020 funds--they are not the same. But what happened is that the objective of these [target date] funds is to provide the appropriate asset allocation so that as a person saves in these vehicles until they retire, they have the right portfolio to get them the appropriate nest egg. Because the ratings agencies were just looking at performance, saying this 2010 fund is better because it outperformed by X%, well it was all coming down to 'What is the commitment to equities?' I don't think that's the way you should look at these funds because the objective is to provide an end result to the investor.

Concerning the investing environment in general these days, what is your recommendation?

It's been outstanding. With the downturn we had in the fourth quarter and the first two months [of 2009] the market bottomed and in early March it presented, for active managers across the board, an unbelievable opportunity because all stocks were beaten down. To go in and do true valuation you could really pick the stocks that were going to provide the greatest value and I think that's why we see phenomenal numbers for active managers versus index. Putnam's had a terrific year performance wise and it's all been through stock selection and that's fundamental research. So it's a great time to invest. I do think if people are saving for retirement to be in a vehicle earning less than 1% you are never going to reach your goal. I know sometimes when you go through a down period like we've gone through it's tough to get back in, but people should get back in and absolute return is a great way to get back in. There are unbelievable opportunities out there across asset classes. This is not just an equity play, bond funds are generating for the investors equity-type returns this year.

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