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The Big 401k Fiduciary Question: Target Date or Target Risk?

May 12
00:01 2015

What’s Better? Target Date Funds or Target Risk Funds?

“Target Date Funds have been the belle of the 401k plan sponsor’s ball,” says Layton Cox, Director of Retirement Plan Consulting at Pathways Financial Partners in Tucson, Arizona. He says, “With more than $650 Billion in Assets, Target Date Funds are here to stay. A lot of their assets came from the veteran Target Risk Funds.” With target date funds becoming increasingly popular, there remains concern they may be promising more than they can deliver. But first, let’s explore the nature of these beasts.

Target Date Funds vs. Target Risk Funds: What’s the Difference?

At broad brush, both types of funds appear similar. They’re both balanced funds that, each in their own way, appeal to a wide swath of the investing population. Target Date Funds, the relatively newer version of the two, skyrocketed in popularity when the DOL specifically named them as a Qualified Default Investment Alternative (QDIA). Target Risk Funds, also known as “Lifestyle Funds” or, in even older parlance, simple called “Balanced Funds,” also represent QDIA candidates, but have the unfortunate bad luck of not possessing a generally agreed upon name, making them more difficult to brand.

Despite the similarities, significant differences do exist. “A Target Date Fund is a specialty mutual fund that automatically reduces risk by resetting the allocation of stocks, bonds and cash within the fund as it gets closer to a target retirement date (e.g. 2045 Fund). A Target Risk Fund is a mutual fund whose asset allocation (mix of stocks, bonds and cash) maintains a predetermined risk profile (e.g. aggressive to conservative),” says Jason Woon, Founder of Main Street 401k, L3C based in the San Francisco/Bay Area.

Digging deeper, Martha Spano, Principal, Investment Consulting Wealth Practice at Buck Consultants in Los Angeles, California, says, “Target Risk Funds are multi asset class portfolios that have specific risk postures but with a static asset allocation. Target Date Funds are also multi-asset class portfolios that are keyed to a particular retirement date. But Target Date Funds have more moving parts in that they employ a glide path which rolls down more risky assets to less riskier assets as the fund nears the retirement endpoint, and they uses a periodic rebalancing to reset the asset allocations.”

Along the lines of “moving parts,” it’s easy to see how the investing public has difficulty distinguishing between the two types of funds. “A Target Date Fund is a sequence of Target Risk Funds, starting with a high risk fund for young employees and moving progressively toward lower risk funds as the participant approaches retirement,” says Ronald Surz, President of Target Date Solutions located in San Clemente California. He goes on to say, “Individual participants might prefer one over the other. A participant who doesn’t know how much risk he wants may ‘trust’ the Target Date Fund, but should definitely do homework to understand the Target Date Fund his employer has selected for the 401k platform. If the participant doesn’t want to make a decision, he will default to the employer.”

The Unquestioned Popularity of Target Date Funds – More than Just Great Branding:

The allure of Target Date Funds rests in their appearance of straightforwardness. Daniel R. Zajac, Partner at SimoneZajac Wealth Management Group, LLC in Exton, Pennsylvania says they are “simple, they make it easy for someone with no investment knowledge to make a decision. If you want to retire in 2050, pick the 2050 fund! Retire in 2030, pick the 2030 fund.”

Spano agrees, saying “Target Date Funds’s are easier to visualize in the future and are anchored to a specific year, specifically the year of retirement.” She mentions another attractive to weary investor when she says, “Target Date Funds  periodically change their asset allocation mix through the use of a glide path – going from a high allocation of  more risky assets (equities) to more low risk assets (fixed income). The use of the glide path attempts to lessen the risk inherent in the portfolios as the individual attains retirement age. This is done automatically and the participant does not have to do anything as he/she progresses towards retirement age. Also the investment management, performance, and the rebalancing are taken care of by the plans’ fiduciaries. The only thing left for the participant to do is review their individual statements.”

With Target Date Funds, retirement savers are taught they need know only one number – and it’s a number near and dear to their heart. Cox says, “When used as a QDIA, Target Date Funds eliminate the plan sponsor’s choice. Instead everyone in the QDIA is appropriately matched with the correct Target Date Fund based upon their birthday.”

As far as paying attention to retirement, something employees tend to be loath to do, Target Date Funds offer the infamous “set-it-and-forget” solution tempting to many. “Good asset management generally dictates that risk decreases as an investor approaches the time when they need to shift from accumulating their assets, to using those assets to generate an income in retirement. Target date funds ensures that this happens automatically,” says TJ Tillman, managing partner and wealth adviser at Empire Wealth Management in Gilbert, Arizona.

Additionally, the fact an entire industry has geared its marketing effort towards the promotion of Target Date Funds helps considerably. Tillman says, “Target Date Funds are much more well-known to individual investors than Target Risk Funds. Target Date Funds have become extremely popular because of the ease of implementation and the appearance of automatic asset management.”

Yet the very existence of this “appearance” causes some well-documented skepticism among professionals. Murray Carter, Executive VP – Wealth Management at CSG Capital partners of Janney Montgomery Scott in Washington DC, says, “Target Date Funds have been [made to] appear to fit with retirement plans better, providing an easy discussion of ‘what year will you turn 65.’ This would then give the appearance of needing minimal explanation. The 401k and mutual fund industry finds it easier to make a global assumption that if you are 40 years old and will retire at age 65 you should just pick the Target 2040 fund.”

The deceptive effortlessness of “set-it-and-forget-it” may, however, be a Siren for retirement savers. “Target date funds are easy to understand,” says Zajac says. “If you know when you want to retire, making an investment selection is bulletproof. Additionally, if you are of the school of thought that you should be a ‘safer’ investor as you near retirement, the target date ‘set-it-and-forget-it’ model works well (although I would argue being too safe too soon could negatively affect your retirement).”

Target Date Funds Brewing Problem:

“The inherent problem with Target Date Funds is that they assign risk based solely on a person’s age and projected retirement date,” says Tillman. “If I’m an investor who is retiring in 30 years but I don’t want to risk much of the money I’ve saved, a Target Date Fund will be too aggressive for me. The potential way to overcome this is by using a date that’s closer than your projected retirement date if you’re less aggressive (because the asset allocation will be less risky) or a longer date if you’re a more aggressive investor (asset allocation will be more aggressive in a fund with a date farther in the future).”

 

Age may be a proxy for one’s return needs, but it is hardly the only one. Unfortunately, Target Date Funds assume age is the only important factor when determining the investment needs of the retirement saver. Carter says, “Target Date Funds have an innate limitation…they are meant to fit everyone in a particular age bracket as if they all assume the same level of risk. Depending on the vendor different owners of these funds are going to have different opinions of them. While investors don’t complain about their level of risk in a rising market, when the next market correction/downturn occurs, owners will then begin to understand and dislike, the risk component within their investment. Unfortunately, investors don’t understand that just because a number of mutual fund companies offer funds with the same target date, they may have widely different portfolios and risk.”

Cox sees Target Date Funds as having two additional problems: lack of uniformity across the fund families and lack of customization across the individual investor levels. “Comparing some Target Date Fund Families can be as difficult as comparing apples to oranges,” he says. “Certain fund families have their strong suites (growth stocks, value stocks, bonds, high yield, etc…) and they emphasize that into their Target Date Funds. This makes it difficult to create a benchmark for Target Date Funds. Without a benchmark how does a plan sponsor know if their Target Date Fund Family is up to par? Luckily, dedicated plan advisers have access to tools that can compare Target Date Funds to their peer group. As of now, this is the best way to ‘rank’ Target Date Funds.”

When Target Date Funds with the same “target date” can consist of different underlying investments, different asset allocations, and different “to/though” objectives, do true peer groups really exist? And if such comparisons present a challenge, how can plan sponsors undertake the appropriate due diligence when selecting Target Date Funds. Surz, who is researching a new rating system for Target Date Funds, says, “The #1 BIG problem with Target Date Funds is that they are not being vetted, so participants are not getting the best; they’re just getting the biggest. More than 60% of this trillion dollar industry is with the Big 3 bundled service providers, which might be fine if their Target Date Funds were superior, but they’re not. The Big 3 2010 funds lost more than 25% in 2008, and they have increased risk since. They’re ticking time bombs. Fiduciaries are relying on the false beliefs that (1) any QDIA will do, and (2) you can’t go wrong with the most popular brands. This problem will only be fixed with class action lawsuits. The basis for the lawsuits will be excessive risk, as manifested by catastrophic losses. The excessive fee mess was not addressed until there were successful lawsuits. So it will be with Target Date Funds.”

Do Target Risk Funds Offer a Viable Solution?

What happens when a young person inherits a huge trust fund? What happens when a retiring employee needs to continue to invest for equity-like returns to have a chance to funds his retirement years? Clearly, Target Date Funds are not designed to solve these problems. Tillman says, “Some investors may find themselves taking on too much or too little risk by utilizing a Target Date Fund. No two investors risk appetites are exactly alike and Target Risk Funds can be advantageous in that they ensure that risk is based on an investor’s specific tolerance and not solely on the length of time until a future date.”

For many professionals, the investment equation depends more on the specific risk/return parameters of the individual investor and to a lesser extent on that person’s age (although age does continue to be a factor). “Target Risks Funds align to an employee’s specific risk profile with an appropriate asset allocation,” says Woon. “It is not uncommon for an older participant to have a risk appetite greater than their age would suggest. Conversely, a younger person may be more conservative that his or her peer age group. Target Risk Funds are better utilized in smaller plans where employees have access to a financial advisor that can help them choose their most appropriate Target Risk Fund.”

In their own way, Target Risk Funds offer their own kind of simplicity. Zajac says, “With a Target Risk Fund, you know what you have. The allocation stays the same today, tomorrow, and years from now. The Target Date Fund changes allocations. It takes a concerted effort to track the allocation changes in the portfolio to truly understand the inherit risk tolerance.”

With this simplicity comes easier peer-to-peer comparisons, making the plan sponsor’s due diligence efforts more consistent and less burdensome to document. “Since the Target Risk Funds have a static allocation, they are simpler to administer and benchmark against an appropriate index of same weighted assets,” says Spano.

Surz concludes, “Target Risk Funds are less controversial and easier to understand than Target Date Funds. Most people understand ‘aggressive’ or ‘conservative,’ and [the asset allocations derived from these terms] are relatively consistent across providers. By contrast ‘glide path’ is complicated and in practice widely different across providers.”

It’s not as though Target Risk Funds have no problems. They lack the “set-it-and-forget-it” desirability of Target Date Funds.  “The main problem with target risk is at the same time the main appeal,” Surz says. “They’re constant risk. The appropriate level of risk changes with circumstances. It makes sense to manage to objectives. A target risk fund has an implied expected return that can be matched to those objectives. This matching needs to be periodically revisited. Dr. Frank Sortino calls this ‘Financial Navigation.’ Risk can be reduced when objectives have been exceeded and increased when they have not. Financial navigation requires a professional adviser, something most participants don’t have.”

What’s Easier for the Retirement Saver to Understand?

So which one is it? Target Date Funds of Target Risk Funds?

Zajac says, “I don’t know, to be honest. I like that fact that what you get is what you get. It’s easier to understand a Target Risk Fund. Reason being, Target Date Funds take Target Risk Funds one step further by changing the allocation over time. In understanding a Target Date Fund, you need to know everything about a Target Risk Fund… plus more.”

There is room for debate on this issue, though. Woon says, “Target Date Funds are much easier for employees to understand, but there is a risk of disengagement. In larger plans they are certainly better for the majority of people. However, in the small market place where financial advisors are offering real value, Target Risk Funds will generally serve individuals better as they will more close align to their individual needs. And by the way, on many platforms you can have both options.”

Then there’s the idea of the needs of the employees versus the needs of the plan sponsors. Surz says, “It’s easier for an investor to understand Target Risk Funds, but a plan sponsor choosing a default investment likes the ‘set-it-and-forget-it’ aspect of Target Date Funds, although he doesn’t understand the nuances.”

For some, age remains paramount, the universal language of investing. “I think it’s easier for investors to understand target date funds because they’re intuitive,” says Tillman. “Investors generally understand that as you get older, you don’t want to risk as much of your money because you may not have enough time to recoup it after a downturn.”

Of course, there are those who don’t see retirement savers possessing the time or the inclination to really “get” either of these options. “Most 401k investors do not understand the nuances of either the Target Date Fund or the Target Risk Fund,” says Spano, “from the asset classes themselves, to the portfolio construction, to the asset allocation, or even the fees. But the reality is that participants can determine when their retirement date as opposed to determining their risk posture. So Target Date Funds might appear to be easier to use.”

On the other hand, there are those who have greater confidence in the abilities of the investors, though less in the products themselves. Carter says, “I think the average 401k investor can choose easily by risk or by date. However, my issue is the average investor has no idea of what has been determined the mix given their chosen date or risk tolerance. There are no standards throughout the industry. Also, the issuers of these investments are routinely tinkering with their portfolios and some can make fairly significant changes that without a Plan Sponsor supporting participant education, most investors won’t realize or understand how these changes may affect them.”

Then again, when it comes to retirement, there’s on one bottom-line all employees understand. “For the average 401k investor Target Risk Funds are easier to understand,” says Cox. “An investor knows that an aggressive fund shoots higher but sometimes falls lower. Investors understand aggressive, moderate, and conservative. It’s harder for an investor to completely grasp the concept of a glide path. 2055, 2060, and 2020 are all just numbers without meaning to a lot of investors. If the Target Date Fund asks the investor, when do you want to retire? Wouldn’t the investor say, ‘Tomorrow’?”

Are you interested in discovering more about issues confronting 401k fiduciaries? If you buy Mr. Carosa’s book 401(k) Fiduciary Solutions, you’ll have at your fingertips a valuable reference covering the wide spectrum of How-To’s every 401k plan sponsor and service provider wants and needs to know.

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. His new book Hey! What’s My Number? – How to Increase the Odds You Will Retire in Comfort is available at your favorite bookstore.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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4 Comments

  1. Dick Purcell
    Dick Purcell May 12, 23:30

    Chris, you’ve exposed more of how terrible investment-advisor training is. All slick words. Zero about the purpose, DOLLARS for future YEARS.
    No wonder people aren’t investing enough. They sense the hollow slickness of the words.
    “Fiduciary” without dollars-and-years rules will be worse.
    The best hope for getting investor guidance out of the swamp created by investment-advisor mis-training is robos.

  2. MICHAEL HATLEE
    MICHAEL HATLEE May 29, 08:47

    In the small and micro plan market where interaction with an advisor is the norm, I have found it beneficial to use both target date and target risk. In this case however, it is vitally important to interact with the participant. A participant with a risk tolerance that matches what you would expect given their time horizon may be better suited in the target date options. For a participant who clearly has a risk tolerance that does not match their time horizon target risk may be the better solution.

    I think this combination works better than using target date funds and advising more risk averse participants to choose a target date fund with a target date that is closer than their retirement. Traveling down this road removes some of the intuitive allure of the target date option and generally leaves behind a confused participant.

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