(This is the fifth in a series of five articles on Target Date Funds)
Target Date Funds (TDFs) have successfully addressed a primary concern of both the 401k participant and the ERISA fiduciary. The Department of Labor identified TDFs as more appropriate long-term investment defaults than money markets and 
stable value funds. Unfortunately, these products have proved more problematic than expected, particularly for short-term investors, and it’s unclear if the basic nature of TDFs can surmount their short-comings. So, are their alternatives?
These headlines spell the extent of the damage done by and to TDFs: “Many Target-Date Funds Miss Their Mark,” U.S. News, (November 14, 2008), “Kohl Says Target-Date Funds May Present Conflicts of Interest,” (Bloomberg, October 28, 2009), “Target-Date Funds Go Under the Microscope,” (US News, October 30, 2009), “Participant Behaviors do not Match Target Date Assumptions,” (PlanSponsor, January 11, 2010), “Target Date Funds are no sure fix for retirement,” (Pittsburgh Tribune-Review, March 22, 2010), “Debating Target-Date Funds’ Tricky Labels,” (Wall Street Journal, August 24, 2010), “Target date turnover troubles big firms,” (Investment News, August 29, 2010), and “The Hedge Fund Lurking in Your 401k,” (Wall Street Journal, September 4, 2010).
With all these problems, it’s a wonder that only 44 comments were offered during the public comment period the SEC created to attract potential improvements to their proposal. Columnist Chuck Jaffe offers an interesting idea in his recent article (“Target-date fund proposals miss the mark,” MarketWatch, August 29, 2010). Jaffe suggests each target date be accompanied by either a “conservative” or “growth” label. This would account for different return requirements among participants. Some would argue, however, this is no different than a lifestyle fund. Additionally, what’s “conservative” to one investor is “growth” to another. Ironically, though, for years (in the era before the universal acceptance of Modern Portfolio Theory and the subsequent dominance of Morningstar style boxes), mutual funds were assigned objective labels like these. In fact, the SEC still requires mutual funds to declare whether they are “growth,” “income,” “growth and income” and “capital appreciation.”
The DOL itself outlines “safe harbor” alternatives to TDFs (“Fact Sheet – Regulation Relating to Qualified Default Investment Alternatives in Participant-Directed Individual Account Plans”). The first, and easiest to implement, is simply a balanced portfolio managed in the same manner a profit sharing portfolio might be. A balance portfolio default option appears the safest alternative because there’s already a large history of this type of investing. This option might be a managed portfolio of stocks and bonds (in the early days 401k options were offered in this manner) or a managed mix of mutual funds containing different classes or a single balanced fund.
The second DOL alternative is a service where personal accounts are individually managed. “If you have a professional to walk you through on a year-by-year basis, that would overcome the advantages of TDFs,” says Rich Lynch, COO of fi360, “But not all plan sponsors are going to be willing or be able to hope for. Bringing in the adviser is the ideal, but not broadly practical.” Beyond the managed default option, there are practical problems in relying on participants to use a self-managed approach. “Anyone could use a diversified portfolio of funds to mimic a target-date strategy, but most participants don’t manage their portfolios as actively as a target-date manager would,” says Laura Lutton, Editorial Director, Fund Research Group at Morningstar, Inc.
But the fundamental concern may transcend merely rearranging the deck chairs within the TDFs. “Much of ERISA and the interpretation of “prudent man” standards are predicated on Modern Portfolio Theory (MPT) and that is in essence the cornerstone of the construction process of these funds,” says Steven Glasgow, Sr. Vice President at Avondale Partners. “If the world comes to the conclusion that the historically accepted norms for implementation of MPT is flawed (which it is) then, there may be wholesale movement to another approach.”
A growing number of financial professionals agree with Glasgow regarding the diminishment of MPT. While it’s not clear how behavioral finance (the likely successor to MPT) might be used to create better 401k options, we can envision how those products might be constructed. “I’d try to automate acquisition of current savings information and planned retirement, and translate these into a desired return on savings. Then I’d offer a family of desired return funds,” says Ronald J. Surz, President & CEO, PPCA, Inc. This approach, first identified as “Goal-Oriented Targeting” in the October 2005 paper “The Emperor Exposed” in the Journal of Financial Planning, employs techniques recommended by the CFA Institute.
In summary, the issue of TDFs comes down to two different sets of circumstances. In the first case, they generally do a good job of taking investors out of lower yielding default options (although many will acknowledge other funds may do just as good of a job). Secondly, the 401k industry has used these options as “set-it-and-forget-it” choices that may not perform as expected. It is this latter case that may expose the unsuspecting fiduciary to greater liability. It’s clear service providers need to move away from the plug-and-play world of MPT and towards the more interactive world of behavioral finance as they create new and improved products. ERISA plan sponsors interested in reducing their fiduciary liability must stay up-to-date on these developments.
Do have your own thoughts on the alternatives to TDFs? Please leave a comment below and share those ideas with others.
Like this article? You might be interested in reading other articles in this series.
- Intro: 401k Plan Sponsor Lament: Are Target Date Funds the Edsel of the Mutual Fund Industry?
- Part I: A Hidden Fiduciary Liability for Plan Sponsors: The Five Most Critical Problems with Target Date Funds
- Part II: What Every 401k Fiduciary Should Know About Target Date Funds
- Part III: Target Date Funds: DOA or Just a False Start?
- Part IV: Options for 401k Plan Sponsors: Alternatives to Target Date Funds
Wouldn’t the “target return” portfolios be just model portfolios (or balanced funds, or target date funds) with expected (some iteration of historical) return? Wouldn’t the same thing be accomplished by just adding the expected return (and risk) as standard information for model poftfolios?
I cerainly like the idea of closely tying a person’s projected cash flow with the proper model as well.
It is kind of funny that so many seemingly smart people are eshewing MPT, when any alternative to MPT is basically the same thing under a different name. Isn’t any portfolio meerly a sum of its parts?
Additionally, would everyone please stop saying TDF didn’t perform as expected? They performed EXACTLY as expected. What do you think is supposed to happen when we go through the biggest market turmoil in decades? Any investment safe enough or with enough hedging involved to not loose through the recent markets will not provide the long term return necessary due to low yield or high cost (low net yield) needed by most financial plans.
Chris,
Good article. We’ve done something a little bit different than TDFs – never bought into them philosophically. We establish risk-based portfolios in plans and then move from aggressive to conservative as a person ages (usually 5 models). But here is the difference, the “glidepath” is unique to the plan (we think EEs at a firm have similar demographic/economic makeup) and is a recordkeeping function as opposed to a fund function. The recordkeeper does a query each year for specific age changes and those that fall within those ages are repositioned to a more conservative model. For example, a person who turns 62 in 2010 would be repositioned from the moderate model (40/60) to the conservative model (30/70). We dispute anyone who thinks that outcomes can be managed, so we manage the only that can be – risk. This is the QDIA in a number of plans that we advise on. We do these with models (recordkeeper directed), unitized fund of funds or as CIFs. This approach is somewhat common in Europe.
A single balanced fund approach that would have been suitable for the group as a whole (with equity holding amounts somewhere between suitable amounts for the younger workers and the older workers) would have likely performed even worse (in 2008) than a 2010 target date fund with equity holdings that we reasonable for the older workers.