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Are Target Date Funds a Ticking Time Bomb?

February 10
00:43 2015

SEC Commissioner Luis Aguilar believes Target Date Funds (“TDFs”) should be given the same treatment as cigarettes – they both should come with dire warning labels. As reported (see the BenefitsPro article here) and published on the SEC web-site, Aguilar feels “The relentless growth in target date funds is troubling because DCF 1.0studies have shown that investors, and industry professionals alike, do not fully appreciate the risks these funds present.” He points out “Target date funds, however, do not contain guarantees. Investors in these funds are not assured they will have sufficient retirement income at the target date, and there is no guarantee that investors will not lose some, or even all, of their investment.” Furthermore, Aguilar says, “It is imperative that investors better understand the risks presented by target date funds.” He concludes, “With the end of an historic period of low interest rates rapidly approaching, the consequences of investors continuing to be ill-informed about the inherent risks of target date funds are simply too grave.”

Clearly, Aguilar believes the sum of “set it and forget it” equals a ticking time bomb for plan sponsors, fiduciaries, and retirement savers. It will only take the return of the normal market cycle (a.k.a. “the reversion to the mean”) for these powder kegs to detonate. These concerns, as Aguilar states, are not new. Many fiduciary advisers see TDFs as fraught with issues. Surprisingly, there may be a better answer. What is it and why have retirement plans overlooked it?

That TDFs problem have long been recognized is well conceded. Despite this, the situation continues to deteriorate. Ronald J. Surz is president & owner of Target Date Solutions in San Clemente, California and co-author of Fiduciary Handbook for Understanding and Selecting Target Date Funds says, “TDFs have gotten riskier since 2008, especially at the target date, so fiduciaries deserve to get sued, not because they use TDFs but because they have not vetted their selection.” As an example, citing data from his book, he says, “Choosing T. Rowe, Fidelity, or Vanguard is a decision to be 55% in equities at the target date, with much of the balance in long term bonds. Fiduciaries are breaching their duty of care by not protecting beneficiaries from foreseeable harm and by not vetting their selection.”

Aguilar referenced data from Surz interview with FiduciaryNews.com (“Exclusive Interview: Ron Surz Says Regulators Can’t Solve Target Date Fund Problems,” FiduciaryNews.com, June 17, 2014) when he said, “target date fund assets quadrupled since 2008.” What explains this exponential increase?

“One word: ‘simplicity’,” says Francesca E. Federico, Principal and Co-Founder of Twelve Points Wealth Management in Boston, Massachusetts. “Participants in 401k plans choose TDFs for simplicity. ‘When do you want to retire?’ Ok, boom here pick this fund and you are done. It makes it simple and easy to participate in the 401k. Most participants, especially those not familiar with finance and the markets, get overwhelmed easily. So sifting through 25-100 funds (sometimes hundreds) is tedious and daunting and they would rather not participate. TDFs make it easy to participate and manage your 401k.”

The appearance of simplicity best explains the popularity of TDFs, but it also suggests their problem. “Target date funds are great for employees who no longer at the company but have not rolled their plans, great for employees who do not watch their investments, and great for when you have a new sponsor and roll investments into new funds (mapping),” says Holmes Osborne, Principal of Osborne Global Investors, Inc. in Odessa, Missouri. But relatively quick due diligence, a step often ignored by casual investors, can reveal the peril hidden within TDFs. “I have warned my participants that these target date funds are much more aggressive than their names indicate,” says Osborne. “A 2020 target date fund can have much more invested in stocks than the name indicates.”

Just exactly what the “date” of a target date fund means is one of the biggest problems with the product. “‘Date’ is not a static term,” says Richard Friedman, Managing Director of Corporate Retirement Services at IRON Financial, located in Northbrook, Illinois. “All TDF’s have a ‘retirement date’ but the asset allocation of the fund is dependent on glide path of the fund. As an example, many fund families have a 2030 target date series, but some may have 20% equity exposure at the retirement date and others may have 50% equity exposure at the retirement date. The product is not consistent and demands that advisors and plan sponsors thoroughly understand which TDF series they are selecting and why.”

If inconsistency of product labeling is one worry concerning the date, Federico brings up a more fundamental concern. “I’ve come to learn that many people don’t understand the actual date of the fund,” he says. “The ‘date’ is actually the year when an investor will retire or stop buying shares in the fund. Some participants I’ve worked with have thought it was something else entirely – One thought it was the year the fund invests most conservatively. Another woman I worked with thought it was the year when she will withdraw all her money. Another younger participant I worked with thought that the TDF was a guaranteed stream of income when he retired and that the year was when he’ll get the fund’s ‘guaranteed’ income or the first year he’ll be able to withdraw money.”

Perhaps Aguilar is on to something, and Friedman concurs. He says, “The biggest hurdle surrounding TDF’s is the glaring lack of education as to what this product is and what this product is not. There are numerous studies that show participants lack of understanding of TDF’s – from the belief that they offer lifetime income at retirement to the belief that these funds are ‘conservative’ at retirement. This is one of the most critical value adds that a plan advisor can offer participants. Education! Make sure participants understand the product mainly from the view point of who should not invest in TDF’s.”

While this doesn’t apply to all TDFs, many suffer from a lack of transparency. Federico says, “Most TDFs are constructed entirely from mutual funds from their sponsoring organization. For example, the Fidelity Freedom 2030 Fund consists of 23 different investments, each of which is a Fidelity mutual fund. There is a fee for the underlying mutual funds in the TDF and another whole layer of fees for managing the funds.”

Layering funds on top of funds can hide more than fees. “Another item that we research is the makeup of the TDF itself,” says Friedman. “What funds are being used inside the TDF? Are they index funds, active funds, a combination of both? And as part of that analysis we look at the track record of those funds. What we are trying to avoid is fund companies putting brand new funds with no track record into the TDF to seed the funds. The whole is a sum of the parts and we treat it just that way.”

So, with all these problems, why are so few complaining? “Bull markets mask many inefficiencies and few plan sponsors and advisors do not want to fix what is not broke,” says Friedman. “Lack of understanding of the TDF product would rear its ugly head in a bear market, like it did in 2008-2009.”

“As always, everyone gets lured in to complacency by a good market,” says Murray Carter, Executive Vice President – Wealth Management at CSG Capital Partners of Janney Montgomery Scott LLC in Washington DC. “When we go through another market downturn the chorus of complaints will again surface.” And what will be the cause of that “chorus of complaints”? “In the last few years as some TDFs have lagged in performance they have changed their glide paths to more equities,” says Carter. “This changes the risk characteristics of the original decision. It is my belief that many plan sponsors (the fiduciaries), let alone the participants, don’t understand the investments. The risk is driven by education or lack thereof.”

There has long existed a viable alternative to TDFs. Maybe because it had its heyday in the 1990s and lacks the sheen of newness of TDFs can explain why it’s often overlooked. “Target Risk funds or ‘lifestyle’ funds match the risk profile of the investor (or rather the investor selects the lifestyle fund that matches his or her risk profile),” says Federico. “Aggressive investors will want an aggressive lifestyle fund, conservative investors will want conservative lifestyle funds, and the lifestyle fund won’t change its risk profile as the investor ages, they change it (unlike the TDF). A lifestyle fund blends stocks, bonds and other investments to try to achieve a certain level of overall risk exposure. For example, if you determined that you are comfortable taking a moderate level of risk, you could find a lifestyle fund which attempts to target that risk level, and which attempts to maintain that level of risk exposure over time.”

Target risk funds have the advantage over target date funds in that they are easier to support the retirement saver’s personal goals. “We believe that they are a better alternative,” says Friedman. “When you look at the demographics of asset allocation for a typical plan, they are more aligned with a balanced fund than they are a TDF. Many people who are invested in TDF’s are done so on a default basis. Many of these people have historically shied away from retirement plans. Some may truly have an aggressive investment stance but many others are distrusting of the stock market and can range from conservative to risk adverse. The available QDIA options do not allow for investments that meet the needs of those not comfortable with risk. In our opinion a balanced fund offers ‘balance’ where the majority of participants can find some level of comfort.”

Paul Ruedi, CEO at Ruedi Wealth Management in Champaign, Illinois feels that people like “Easy.” He says, “All they really want to do is take a pill. The problem is Wall Street is happy to provide it, even if it is not the best approach. While intuitively an age based approach (target date generically – glide path) makes sense, when you actually run a client’s plan against historical returns and simulated returns, I have never found a case where a simple rule of thumb such as a glide path approach had the highest probability of success – quite the contrary. Advisers must grow past intuition based rules of thumbs that seem to make sense. Eventually, as more advisers recognize the benefits of goals-based wealth management – the benefit to their clients’ lives – they will actually do some work and test their theories.  If they do, they will quickly find the weakness in the age based (i.e., target date) strategy.”

What does this therefore mean? Ruedi says, “There is no pill. There is no basis for the Department of Labor to be so enamored with Target Date Funds. The SEC is concerned for other reasons (transparency, significant allocation differences), but the fact that a simple glide path approach is unlikely to be aligned with the participant’s specific goals (either more risk than necessary or less) should be the biggest concern. Let’s move to a uniform and robust fiduciary standard and demand goals based wealth management. 401k participants will be much better off in my opinion.”

The question remains, though, whether the retirement plan industry can overcome the inertia of TDFs before the ticking stops.

If you’d like to discover other important topics confronting 401k fiduciaries, then you’re invited to explore Mr. Carosa’s book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans. His latest book Hey! What’s My Number? – The One Thing Every Retirement Investor Wants and Needs to Know! does for plan participants what his previous book as done for plan sponsors – and their advisers!

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

4 Comments

  1. Tom Sowanick
    Tom Sowanick February 10, 14:54

    TDFs and TRFs miss the point that risk profling should be an ongoing exercise and not a one and done. TDFs and TRFs are both viable sleeves for a retirement account but should never represent the entire investment. Because of the cyclical nature of investments and the overlay of monetary policies and fiscal policies it is quite common to find equities to be less volatile than fixed income. This is particularly true at inflection points in the cycle. In summary, you should always be willing to pay for advice but not be willing to over pay for simplified structures.

  2. Ron Surz
    Ron Surz February 10, 20:01

    Thanks for quoting me & mentioning our book Chris.

    With a $trillion at stake & growing you’d think things would be getting better, but the situation is getting worse. Advisors and investment-only managers want a piece of this $trillion pie, so they’re touting custom TDFs, claiming they can deliver on the crazy objectives of replacing pay and managing longevity risk. No glide path can realistically achieve these objectives. Saving enough is the key, not glide path.

    The DoL encourages fiduciaries to consider workforce demographic. The only demographic that defaulted participants have in common is lack of financial sophistication, so of course they don’t understand — that’s why they default. This naivete argues for protection / safety, especially at the target date. The fact is TDF providers, like Fidelity, have increased their equity allocation, and overall risk because the performance horse race is going to the risky, like T Rowe. As you say, the time bomb is getting loaded with some powerful explosives.

  3. Christopher Carosa, CTFA
    Christopher Carosa, CTFA Author February 16, 19:08

    Bill: Very powerful! Thanks!

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