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Recent Market Volatility Has Revealed This About Target Date Funds

Recent Market Volatility Has Revealed This About Target Date Funds
January 15
00:03 2019

The numbers are in. The fourth quarter of 2018 brought the markets well beyond correction territory and to the precipice of a bear market. For the first time since the 2008/2009 market crash, we’ve had the opportunity to glimpse at whether the various “fixes” to target date funds following that debacle have created a more durable vehicle. While the jury may still be out, we may have stumbled upon one unexpected benefit to target date funds (and default investments in general).

“Qualified Default Investment Options” (“QDIOs”), officially became part of the defined contribution lexicon with the 2006 Pension Protection Act. The opportunity to avoid having to making (an often difficult) investment decision has permitted an increasing number of retirement savers to simply have their money go into the default option. While QDIOs can fall into three broad categories, target date funds have become the most popular. “Most plan participants find the dizzying array of investment options within their plan somewhat intimidating,” says Lloyd A. Sacks, Managing Director, Sacks & Associates Wealth Management, Bridgewater, New Jersey. “Many participants will contribute a regular amount to either an index fund popular within their plan, target date funds based on their anticipated date of retirement, or a pre-allocated mix of multiple plan offerings.”

Though we’ve seen a fusillade of articles detailing the concern that recent market volatility might spook investors, this may not apply to those selecting QDIOs. “They are less likely to be concerned because they have chosen to let their default options guide their investment selections rather than trying to time the market by actively selecting their own investments,” says Charlie Epstein, Founder and CEO, Epstein Financial Services and The 401k Coach in East Longmeadow, Massachusetts.

Ironically, just as public policymakers advocate for greater employee engagement in their retirement plans, it is this very lack of engagement that may best protect them. “Participants who use a default option are generally less involved,” says Mark Painter, founder of EverGuide Financial Group in Berkeley Heights, New Jersey. “If they are less involved, then they tend not to focus on the short-term fluctuations. Given that retirement is years away and saving will continue, the defaulters will usually keep the investments on autopilot.”

Those who are most engaged tend to fall prey to poor decision making that usually results from heightened market volatility. “Defaulted participants are unengaged, which is why they’re in the QDIA to begin with,” says Matt Fleck, Vice President at Axia Advisory in Indianapolis, Indiana. “Fortunately, defaulted participants using an age-appropriate QDIA are typically better allocated and more broadly diversified than the do-it-yourselfers. The engaged participants are the ones who think they can beat the market and often make changes at the perfectly wrong time.”

Justin Goldstein, Director & Principal of Plan Advisory Services at Bronfman Rothschild Plan Advisors in Madison, Wisconsin, sees do-it-yourselfers – participants pick and choosing their own investments – falling into two camps. He says, “The first group feels that they need to be actively trading and moving money around. This is usually not the approach to take in the middle of a volatile period. As the old saying goes, time in the market is better than timing the market. The second group of do-it-yourselfers are the ones that set their allocation once and then never look at it again. This is obviously not a great strategy either since they typically aren’t rebalancing or adjusting overall allocations as they get closer to retirement. This can lead them to have an allocation and performance that may not align with what they want.” Goldstein contrast these do-it-yourselfers to participants using a default option. “Those using a default option typically understand that target date funds are designed to take care of the asset allocation for them depending on their age. These participants can sometime also be less engaged in the plan and may not even realize the extent that market volatility is affecting their balance. When taking a long-term approach, sometimes it’s better to ignore the volatility and let the strategy work for you.”

There’s a very strong behavioral reason why participants using QDIOs may be more forgiving during volatile markets. Davey Quinn, SVP of Investment Management at United Income in Washington, D.C., says, “Generally, when a participant makes their own investment selection, they have ownership over that decision. And, like any decision, ownership can lead to regret if the decision does not turn out well. Whereas a participant that chooses the default option has less ownership, since that decision is managed, or ‘owned,’ by someone else. That is not to say that participants shouldn’t make their own decisions, since oftentimes with the right education they can make more informed, personalized choices. It’s important to stress though that the last thing participants should do is change their selections after bad returns, because that can lead to lower wealth over time by selling near the lows.”

Lack of engagement has a downside, as we discovered following the 2008/09 downturn. Ten years ago, participants were unpleasantly surprised when they found out their target date funds weren’t as “safe” as they were led to understand. “If a participant is utilizing the default option the assumption is a proactive decision regarding the investment mix was not made,” says Scott K. Laue, a Financial Advisor at Savant Capital Management, Rockford, Illinois. “Typically, the participant isn’t as in tune with their retirement plan balances as others. The default options tend to be age based – for instance a participant under the age of 50 might be 80% in equities and 20% in fixed income. With this longer time horizon this allocation seems to make sense. On the other end a participant over the age of 60 might be 40% equities and while not overly aggressive it at least affords some opportunity for growth and keeping up with inflation.”

Laue continues, “Target date funds were a good brainchild of the mutual fund industry particularly for those less informed participants. While all are different, the glide paths tend to get more conservative as the retirement date nears and it’s my experience that most tend to become too conservative. For instance, the Vanguard 2020 fund has a mix of 55% equities, 45% Fixed income. Unless the pot is big enough, I’d be concerned if I retired at age 60, whether the growth engine would be strong enough given the relatively low interest rate environment we continue to find ourselves in, to last potentially 30+ years for me and my spouse. So, the target date strategy is a good place to start the conversation, but additional circumstances ought to be considered – such as legacy and charitable inclinations, income needs, spending habits particularly early on in retirement, etc.”

One of the big issues that came out of the 2008/09 market crash was the fact the industry had no consistent approach regarding target date funds. “Each target date fund offered is managed in a different fashion,” says Sacks. “There is no ‘industry standard,’ if you can call it that. One target date fund may have an entirely different asset allocation for a given year versus 9 of its peers. This in itself was a big reason for the massive disparity in target date fund performances during the 07/08 downturn and was never rectified or given attention to by regulators.”

Although there remains much inconsistency within the industry with it comes to the definition of target date funds, the industry has made it easier for retirement savers to see how the sausage is being made (if they are so inclined). “There is still a very wide range of target date funds from active to passive, different glide paths, different amount of equity across the board,” says Goldstein. “There is definitely not a ‘standard’ out there. However, there is much more transparency around these funds then back in the recession of 2008/2009. Because of that, I think participants better understand that there is still a fair amount of equity present in most target date series even at age 65, so volatility can definitely affect performance. However, participants seem more educated in how to their money works for them, and they understand that they still have dollars, even at age 65, that they may not touch for another 15+ years. There are still plenty of participants that get nervous that are using target date funds. They are much better equipped, however, with support, knowledge, and know who to reach out to when they get nervous or have questions about their investments or retirement plan.”

Of course, the Catch-22 of transparency is the participant has to want to look into the window provided by the mutual fund. As we’ve already stated, those using QDIOs tend to want to set it the forget all about it. They aren’t engaged. They’re not motived to look inside their target date fund. This defeats the purpose of transparency and can lead to other problems. “Participants in target-date funds are generally not well informed about the allocation of their portfolio,” says Fleck. “A 65-year-old invested in T. Rowe Price Retirement 2020 (a ‘through fund’) needs to realize they’re 56% invested in the stock market and that the portfolio won’t reach its most conservative allocation until 2050, 30 years after the date in its name. This may not be appropriate for someone thinking about rolling their balance to an IRA in a year from now when they’re thinking about retiring. Target-date investors need to look under the hood of their investment to make sure they understand how much risk they’re taking in their accounts.”

It is situations like these than can raise concerns about the kind of short-term volatility like that experienced by target date funds in the credit-crunch inspired 2008/09 market crash. Though not as extreme as then, the fourth quarter of 2018 may have provided a hint as to whether target date funds have become more durable. “Near term,” says Painter, “target date funds while down for the quarter and year held up relatively well to a full stock allocation.” In fact, while all the major indices were down double-digits in the fourth quarter, Morningstar reports the average losses for all categories of target date funds remained in single digits. For the year, target date funds performed comparable to the broader markets. Of course, longer term target date funds lost more as they held lower percentages of fixed income assets to help mitigate the decline in equities.

Looking ahead, however, bonds might not provide a safe haven in target date funds people may expect of them. “Target date funds were originally designed to help solve the problem of where, and how, to put money to work in a wide array of financial conditions,” says Sacks. “In most cases, a target date fund is better than stashing away money for the future in a low interest-bearing savings account. However, they are not without their shortfalls. A perfect example of this is the individual investor who will retire in let’s say, 2020. The problem is, since we have been in an artificially low interest rate environment for several years, the person invested in this fund has made little to no return on the portion of money in the target date fund that has been allocated to fixed income. In a case like this, the target date fund did not take the current market environment into account when investing this individual’s money, aside from the fact that risk tolerance was also not a consideration. Now that interest rates are rising, those who are invested in target date funds will lose a good amount of money on the fixed income portion invested in a target date fund, since interest rates and prices of fixed income investments have an inverse relationship. In 2008, not one target date retirement mutual fund was positive on the year. To understand why, you really must get into the weeds.”

Are target date funds perfect? Perhaps a better way of asking that question is by saying, “Is anything perfect.” There’s an old adage that states “Don’t let the perfect be the enemy of the good.” Target date funds, while not perfect, appear to be good. “85% of employees contributing to retirement plans state that they don’t know anything about investing and don’t want to know,” says Epstein. “Therefore, a properly structured target date fund with strong up/down capture ratio will mitigate market volatility issues for the average investor. P.S.—This small market correction in the fourth quarter of 2018 is not the 2008/2009 market crash!”

Christopher Carosa is a keynote speaker, journalist, and the author of  401(k) Fiduciary SolutionsHey! What’s My Number? How to Improve the Odds You Will Retire in Comfort, From Cradle to Retirement: The Child IRA, and several other books on innovative retirement solutions, practical business tips, and the history of the wonderful Western New York region. Follow him on TwitterFacebook, and LinkedIn.

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

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