Target date' definition differs among stakeholders

CRAIN'S InvestmentNews, September 20th, 2009

Understanding "to' vs. "through' funds is seen as imperative

By Sam Ali September 20, 2009, 6:01 AM EST

When it comes to picking a target date fund, the instruction manual seems simple enough.

Investors calculate their retirement dates, pick a fund that corresponds to that date – whether it is 2010 or 2020 or 2030 – and then sit back as the fund automatically re-balances their asset allocation among stocks, bonds and cash. The closer they get to retirement, the more conservative the fund gets.

At least that is how it all plays out in marketing brochures.

But last year exposed a number of glaring problems in how these funds are marketed and managed.

High on the list of concerns that have captured the attention of plan sponsors, congressional leaders and regulatory agencies is what the term “target date” actually means.

Although target date funds now serve as the core holdings in a large number of retirement plans, many investors, plan sponsors and fund companies still have very different notions about what the “target” actually represents, experts say.

For investors, the answer seems pretty straightforward. The target date reflects the day they celebrate their 65th birthday, eat some cake and stop going to work.

In other words, most investors assume that they are putting their money in a “to” fund – one that manages their money and insulates them from dramatic losses in the years leading up to their retirement, according to Ron Surz, principal of Target Date Analytics, a consulting and research firm that designs target date fund indexes.

As a result, a significant objective for that type of fund is to preserve capital during the 10 years before retirement, even if the funds lag other funds that have higher equity allocations.

A target date fund that fails to protect an investor's account value as retirement approaches has essentially failed in its primary task, Mr. Surz said.

“Anything that jeopardizes asset value during the five years on either side of retirement is a risk that plan participants should not be taking,” he said.

Using this as a yardstick, nearly all target date funds failed investors last year, Mr. Surz said. The average loss last year among 31 funds with a 2010 target date was almost 25%.

“Most target date funds are "through' funds, designed to serve investors past retirement, to the grave,” Mr. Surz said. That is one reason he thinks investors would be better served if these funds were renamed “target death” funds.”

Fund groups that manage through funds think that investors need to be protected against “lon-gevity risk,” or the risk that plan participants will outlive their retirement fund, said Tom Bowler, the chief investment strategist at PrimeTRUST Advisors.

“They feel strongly that longer life expectations mean there is a high probability that one of the two people in a marriage relationship will live to be age 90,” he said.

As such, most through funds have a high percentage of their assets tied up in stocks even if an investor's retirement date is fast approaching. The average 2010 target date fund had a 45% stock allocation at the end of last year, according to Target Date Analytics.

It is imperative to understand whether a target date fund is a “to” or “through” because it profoundly affects the fund's glide path – the rate at which the asset mix is designed wind down as an investor ages. The glide path is meant to minimize the fund's volatility as the target date nears, gradually paring back an investor's exposure to stocks and shifting to more conservative fixed-income securities.

The aim is to reduce the likelihood of huge losses.

ROUGH LANDING

With through funds, these glide paths often don't find their final “landing spot” until as much as 30 years past the target date, Mr. Bowler said. It is no surprise then that these funds fared the poorest during last year's market meltdown, and ex-posed investors who were set to retire in just a few years to the greatest market losses.

Mr. Bowler said that the large number of investors who relied on target date funds and suffered substantial losses is especially troubling because the Pension Protection Act of 2006 fostered much of the growth in these investment vehicles.

The law encouraged employers to enroll new employees automatically into their retirement savings plan and allowed target date funds to become an acceptable default option if an employee wasn't sure where to invest his or her money. Before 2006, the common default option was a money market mutual fund.

“These funds are permitted as a default option, and there is so much ambiguity as to what the target date means,” said David Dietze, president and chief investment strategist at Point View Financial Services.

“Is it the end game of your working life, or the start of your golden years?” he asked. “I would prefer a higher level of transparency so people understand what they are investing in.”

And investors aren't the only ones who are bewildered and mystified.

“The market risks for some of these funds are very often not fully understood by investment committee members responsible for including them in the 401(k) plan as an investment choice,” Mr. Bowler said.

This is worrisome, because, generally speaking, fiduciaries of qualified retirement plans are liable for the investments in a plan, he said.

This is true even in a 401(k) plan, where a plan fiduciary remains personally liable for investment decisions that plan participants make – one reason that it is critical that fiduciaries understand the investment styles and risk management phi-losophies of the target date funds they select.

Mr. Surz thinks that advisers need to be equally diligent.

“They advise the plan sponsors, so this has become an issue for investment advisers as well,” he said. “They are fiduciaries, and they're on the hook for those decisions.”

Mr. Bowler said the best defense for fiduciaries is a good offense. He said that plan sponsors and fiduciaries of all stripes should do proper due diligence on their target date fund options, or consider hiring someone to help them make prudent evaluations.

“We really stress the due diligence side on the plan sponsor's part. We are big advocates of taking into consideration your employees' demographic, including investment expertise, risk tolerance, savings patterns, and investment activity,” Mr. Bowler said.

“People can opt to take more risk or less risk,” he said. “But the most important question is, "What is the best fit for your population?'”

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