The Promise of Target Date Funds

By Joe Nagengast, Turnstone Advisory Group LLC

arget date funds, often called lifecycle funds, or target maturity funds, offer a terrific solution to one of the most serious problems facing America’s retirement system; that of individuals being responsible for the investment decisions upon which hang much of the success or failure of the nation’s retirement.

A loose definition of a target date fund is a fund with a year in its name, such as Fidelity Freedom 2030, or Vanguard Target Retirement 2015. More precisely, they are dynamic asset allocation funds with a scheduled incremental shift away from risky assets and a proportionate increase in more stable assets. Fund companies manage target date funds as if the investor was going to start drawing out money at the target date. All the allocation decisions are made with that date in mind.

For many years we in the industry bemoaned the horrible condition of individual participants, saddled with the responsibility of acting as chief investment officers of their own retirement funds, and being ill-equipped and/or disinclined to adequately fulfill that role. We insisted the solution was investment education and when that failed, more education, different education, better education.

Two major problems face us as we attempt to guide individual retirement savers. How much do people need to put away and what should they do with it once they’ve put it away? The first problem is by far the greater of the two. Most of us assume that most people are not saving enough for retirement, and while some credible sources have recently questioned that assumption, it is safe to say a great number of individuals will not have enough funds for retirement. No investment strategy can make up for inadequate funding. The strategies of target date funds do not solve that problem. But the second problem is answered squarely by target date funds. Now plan sponsors can offer a family of funds, each with a different target date, and each providing asset allocation, re-balancing and portfolio adjustment over time. No longer do we in the industry have to wring our hands and rack our brains about how miserably our participants are managing their own funds.

Let me repeat. An asset allocation strategy can do nothing to solve the biggest problem facing us as millions approach retirement— inadequate funding— but it can solve the problem of inappropriate asset allocation and its associated ills: too much cash or stable value, too much company stock, performance chasing, failure to rebalance or failure to account for changing personal circumstance (age).

And there is the promise of target date funds. Hand over the responsibility for investing your retirement funds and the fund companies will see to it that the funds are professionally and prudently managed. Of course you can still lose money. Mutual funds are not FDIC insured, may lose value and are not bank guaranteed. Past performance is no guarantee of future results, etc.

Is that enough? Is that all participants and sponsors can expect from target date funds? Is that all they should ask for or require?

Does the date in the name of the fund imply anything further about the nature of the promise? Is an investor unreasonable for believing that a fund named “Retirement 2015” for example, can be expected to deliver the required investment security (assuming adequate funding) for her to retire in the year 2015; that the manager will undertake loss protection strategies adequate to prevent losses to the funds at the time she needs them?

Even though the fund documents, prospectus, fact sheet, etc. all use the required disclosure language about the possibility of loss, the overwhelming message of the fund literature is that you can rest easy. All that stock and bond business and diversification talk can be put aside. All you need to do is choose your retirement date and we, the fund company, will take care of the rest. Are participants wrong for seeing target date funds as a service, more than just a fund?

We need to give some serious attention to how these funds are understood by investors. If our suspicion is true that participants perceive these funds as a service and not just a fund, then the onus is on the fund companies to do one of two things, 1) correct the misperception or, 2) step up to it. While correcting the misperception might sound easy, recall the failure of twenty-five years of defined contribution investment education to achieve its goal. Furthermore, while stepping up to the misperception may sound very difficult, it may not be so onerous. The biggest disconnect is most likely in the probability and magnitude of potential losses to the retirement funds of those approaching, or in retirement.

The overwhelming majority of target date funds use traditional mean variance analysis and diversification across the major asset classes to address the risk of portfolio loss. But enough has been written about this approach to risk to convince anyone familiar with the concepts that it is an inadequate approach to risk. Among other problems with this approach is the false comfort that it gives because of the often cited statistically low probability of loss over “the long term” to an equity portfolio.

As I write this, some very smart people— financial engineers, economists, and other financial theoreticians and practitioners— are working on the problems associated with individual portfolio loss. Solutions exist even if the details need to be worked out.

And there is the extended promise of target date funds.

The investment world has come a long way since the first participant-directed plans were rolled out. Target date funds offer a partial solution to the thorny problem of participant direction.

Now if they could just solve that portfolio loss problem and then move on to the problem of inadequate savings...

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Joe Nagengast is president of Turnstone Advisory Group and is a Certified Employee Benefits Specialist. Craig and Joe are part of a team that recently completed the most comprehensive study ever undertaken of target-date funds. For access to the study, please contact Quinn Keeler at qkeeler@plansponsor.com.

An earlier version of this essay appeared in the International Society of Certified Employee Benefit Specialists’ Newsbriefs, Vol. 26, No.3—May/June 2007 and as a Foreword to "Popping the Hood II, an Analysis of Target Date Funds".