In its December issue, Consumer Reports Money Adviser declared Target Date Funds (TDFs) continued “underperform in volatile markets.” We all remember 2008, when even near-term (e.g., 2010) TDFs lost considerably. Consumer Reports states, “The 
average 2010 target-date fund lost 20 percent of its value, and one fund with that target date lost nearly 40 percent.” Things were so bad for TDFs Congress called for hearings and it appeared TDFs were too broke to fix. While the roller coaster volatility of the 2011 had things pretty much ending up where they started, Consumer Reports took a peak behind the curtain, wondering how these funds fared in the third quarter.
During the third quarter of 2011, the world tried its best to return to 2008. The markets suffered one of their worse quarters. How did TDFs do? Do we see evidence they have learned the lessons of 2008? Are their supposedly “safer” asset allocations helping to protection the retirement assets of 401k investors?
Unfortunately, the answer is a resounding no.
According to Consumer Reports, longer-term TDFs (e.g., 2040, 2045, 2050) greatly underperformed the Russell 3000 index. Things looked marginally better for nearer-term TDFs, but, in general, underperformance was the norm. Worse, 2010 TDFs – those intended to be the safest – also lost money in the third quarter.
No all agree with this singular focus on the third quarter. Richard Ohanesian, President & Partner, Ohanesian/Lecours, Inc. of West Hartford, CT, says, “The differences in returns all happened in Q3. So by looking at just what happened year-to-date in Q3 you missed the overall strong performance of Q1 and Q2. Due to the broad diversification of TDFs exposure to financials (which impacted the U.S. market as well as foreign), emerging markets, foreign markets as well as poor performance in small and mid-cap funds were the contributing factors for the decline in Q3 2011. Q3 was of a magnitude that it displaced the positive returns that most TDF’s experienced in the first six months of the year.”
Still, Ron Surz, President of Target Date Solutions in San Clemente, California, states the better first half performance of 2011 could not cover up the third quarter damage sustained by TDFs. Surz says “TDFs were stress tested in the first 9 months of 2011 and they failed. The typical 2020 fund lost 7.7%, which is only 1% better than the 8.7% loss suffered by the S&P500. 2020 funds should be positioned to defend because the target date is near. As for longer dated funds, the typical 2040 fund lost even more than the S&P, declining 12%. And worst of all 2010 funds lost 4%; these funds are presumably for those already in retirement, who can ill afford losses.”
It appears the lessons of 2008 have not yet been implemented. Ohanesian says, “Most TDF’s didn’t significantly change their allocation mix from 2008/09 period vs 2011.” Surz agrees, saying “Buddha said ‘Impermanence is eternal.’ But not so with target date funds, at least not yet. TDFs should have become more defensive as a result of the 2008 fiasco. Stock markets in the 1st 9 months of 2011 provided a defensive test, with US markets declining 9% and foreign markets declining 15%. The sad fact is that TDFs failed this stress test, primarily because little has changed.”
Is this inconsistency enough to cause the DOL to revisit the continued viability of using TDFs as default funds? Martha Spano, a principal, for Buck Consultants in Los Angeles says, “If you look at calendar year returns for comparators (i.e., 2040 TDF versus aggressive lifestyle funds), it does appear that the lifestyle funds did better. However, it is important to note that the lifestyle funds typically have a lower equity exposure than the 2040 TDFs (65-70% versus 80-90%). Also the lifestyle funds do not usually have significant international exposure and that exposure did hurt the TDFs last year because of negative returns.”
Surz still believes in TDFs. He says “I think the concept of a TDF is good, so the DOL’s efforts should be focused on putting fear into the hearts of fiduciaries who should be vetting TDFs but are not.”
Timothy R. Yee, Principal at Green Retirement Plans, Inc. in Oakland, California, worries revisiting qualified default funds might do more harm than good. He says “the focus should not be on revisiting the QDIA issue again as that can result in performance chasing. Better the investing public understand all investments should be based on the investor’s time horizon/risk tolerance, etc and that results will vary. A consistently poor performing fund (whether Lifestyle, TDF, or whatever) will have its manager removed.”
“I’m not sure if the issue is the funds themselves or the fact that there is much misconception among participants as to what they should expect,” says Roger Wohlner, CFP®, a fee-only financial adviser from Chicago. He continues, “Much of this likely arises from poor communications from the fund companies and some from a lack of understanding on the part of the plan participants. From the fund company perspective, these portfolios are either ‘to’ or ‘through’ retirement vehicles, the latter by their nature will take more risk.”
James F. Sampson, Managing Principal at Cornerstone Retirement Advisors, LLC in Warwick, RI also feels it’s a matter of focusing on the right thing, not changing horses in mid-stream. He says, “This is not a matter of the DOL revisiting the Default List; the focus instead should be on the composition of a TDF in the ‘retirement phase’ of its glide path. There are far too many TDFs that are more aggressive at retirement age than most participants would expect. No one has a problem with a fund 20 years away from retirement losing money in a down year; it’s the vintage closer to retirement age where participants feel they should be in a safer mix. Maybe the DOL should have some requirements for TDFs to be safer in those last 5-10 years of savings. And if the fund companies truly believe that a “through” strategy is more appropriate than a “to” strategy, they should have to incorporate some kind of retirement income mechanism into the portfolio to protect from losses, when for most, it’s too late to do anything about them.”
Maybe the changing 401k world will ultimately best resolve the issues surrounding TDFs. Wohlner says “fund companies assume that all participants will stay in the TDFs to and into retirement. Anecdotally I’m guessing many folks simply roll their 401k balances over at some point after leaving their employer, rendering the glide path irrelevant in their case. From my purely biased perspective, I think the better answer is to make access available for the participants to unconflicted, fee-only advisors to provide direct, specific investment and retirement advice to the plan participants. This is a far better solution in my opinion than the one-size-fits-all suites of TDFs.”
Perhaps it’s useful to recall why we have qualified default funds in the first place. Spano reminds us of the original purpose of TDFs when she says “They have gone a long way to get participants out of the stable value mindset and gain some equity exposure for the long-term adequacy of retirement benefits.” One is left to wonder how much longer this justification will continue to work in light of the changing dynamics of the 401k marketplace Wohlner alludes to?
I’ve be appalled at how poorly our Fidelity Target Date Funds have been performing, not just over the last few quarters but even the 5 year returns have been quite poor. As a plan sponsor, the issue that we’ve continually run into is that the administrators only have one offering for target date funds on their platform and you cannot switch them out for either a better performing fund or one with lower fees.
Having these funds as the safe harbor default funds definitely needs to be re-evaluated and perhaps some caveats need to be added to the rule. If the fund fees are over x and performance is in the bottom quartile of performance for x quarters, then it can’t be used as the default fund.
We actually sent out a special note to individuals enrolled in our target date funds and strongly recommended that individuals review the performance of the fund they are enrolled in and provided them with the contact information of our advisor to help them evaluate if another option might be better.
Thanks for quoting me Chris. Here are a few observations:
There is no fiduciary upside to taking risk at the target date. Only downside.
Check me out on this. The objectives stated in sales presentations are nowhere to be found in prospectuses and factsheets. Replacing pay and managing longevity risk are not objectives at all — they’re hopes. An objective without a sensible course of action is a hope.
A much better, and realistic, objective is don’t lose money — it should be the Hippocratic oath of target date funds. A 2nd objective can be earn as much you can but don’t lose money.
Many read my writings & view them as normative — the way things should be, even if they are currently not. Fact is that one target date family is following my recommendations, & they were the best performing funds in 2011, which was a year that stress tested TDFs. SMART collective investment trusts on Hand Benefit & Trust in Houston are the real deal, with a real live 3-year track record that is stellar.