Target date funds aren't a panacea

Target date funds are popular among many employers and fund managers. They are marketed as age-appropriate diversified portfolios and promoted as sophisticated, easy-to-use funds. However, target date funds are no panacea. They are controversial among financial economists, insufficiently regulated and sometimes costly and poorly diversified. 2008 further highlighted some of the serious structural problems with target date funds as default retirement investments and raised questions as to whether Labor Department fiduciary relief should be revoked. Target date fund glide paths are age-based rules that typically decrease equity risk as retirement date approaches. Glide path risk varies widely across fund families for the same target date. In 2008, equity exposures for 2010 funds ranged from 26% to 72%. This reflects the fact that there is no consensus — in theory or in practice — for defining age-based stock-to-bond levels for investing. The variation helps explain the wide range of desultory performance experienced by investors in 2008. Losses for 2010 target date funds averaged 23%; the worst performer was down 42%, compared with a 37% loss in the S&P 500. Many were disappointed with their supposedly conservative retirement investments. Target date funds are risky relative to simpler alternatives such as balanced or target risk funds because performance is largely dependent on the sequence of returns rather than risk level over the investment horizon. Target date funds perform well when equity market returns decline — and poorly when they rise — over the investment horizon. Yet this implicit structural bet is not explained to investors. Furthermore, a recent empirical study found that investors were better off if the glide path was inverted. Target date fund age-based rules ignore the important issue of lifestyle changes over time. As individuals age, many factors affecting an appropriate investment risk level may change, including income level, investments, health and objectives. Locking in to a set target date glide path can be a very high price to pay for inappropriate risk management over an individual's investing life.
THE MYTH OF AGE-BASED RISK Age-based risk management is a dangerous myth that is not only irrelevant for many investors, it might even be perversely related to their interests. It is not supported by financial theory. In fact, academic studies often advocate increasing risk to offset decreasing risky human capital as one ages. To quote economist Paul Samuelson, “investing for many periods does not itself introduce extra tolerance for riskiness at early, or any, stages in life.” In practice, brokers and advisers may recommend a reduction in equity exposure near retirement. The objective is to avoid last-minute downturns in the market when an individual is about to retire. This is sensible advice when investors are content with their accumulated wealth and do not want to risk potential loss, but does not apply to all investors. Age is also loosely associated with risk level based on the notion that stocks tend to outperform bonds on average over time. Consequently, brokers and advisers tend to recommend significant equity exposure as long as an investor has enough of an investment horizon to ride out troughs and peaks. Neither argument rationalizes the target date fund glide path. Declining age-based risk may work against the interests of many long-term investors. The empirical evidence that stocks typically outperform bonds over time is a strong argument against declining equity exposure. Moreover, target date funds may encourage recklessness for the young and excessive conservativeness for the elderly; an unemployed 25-year-old may rightfully be far more conservative than a wealthy octogenarian. Empirical studies on educated investors suggest that objectives and liabilities determine behavior, but age tends to be irrelevant. Target date funds also face management and fee issues. Expense ratios can be high relative to passive fund alternatives, and managers of target date funds may select in-house funds over superior alternatives. Some fund managers deviate from glide path risk levels in order to time the market, but empirical studies show that market timing increases risk and is often unsuccessful for enhancing long-term performance. All of these issues can add to the risk and reduce the performance of TDFs.
A BETTER ALTERNATIVE A “balanced” target risk fund has a diversified asset allocation where the stock-to-bond split is approximately 60/40. In contrast to regular target date funds, balanced funds feature risk transparency as well as long-term capital market neutrality. Since a balanced portfolio is roughly equal to the average portfolio of capitalization-weighted index funds, deviations from it represent underweighting some segments of the economy and overweighting others. An effectively diversified, low-fee, balanced target risk fund is often an appropriate default investment for meeting long-term retirement objectives for many investors. Effective retirement investing requires access to various risk levels in order to meet investor objectives and preferences appropriately. In practice, families of target risk funds that span a spectrum of risk levels are often used as frameworks for retirement investing. Target risk funds do not promote lock-in investing. Target risk funds encourage neither reckless investment for the young nor overly conservative investment for the elderly. Furthermore, target risk funds allow for investment risk to evolve naturally, based on personal circumstances or if systemic risk changes dramatically. Target risk funds offer similar diversification and investment benefits without age-based risk misconceptions and drawbacks. A family of target risk funds — with appropriate diversification and disclosure, and additional education and advice — may provide the most appropriate investment framework for meeting DOL default fund objectives. [Richard O. Michaud is president and chief investment officer of New Frontier Advisors LLC. Robert O. Michaud is the company's managing director of research and development. NFA manages target risk model portfolios for advisers and their clients.]