Analyst Spotlight Archive

Target Date Funds

Target date funds are defined by four characteristics that help investors prepare for retirement: they provide diversification across asset classes, they avoid extreme asset allocations, they are automatically rebalanced periodically to maintain their target asset allocation, and their asset allocation is adjusted (according to the glide path) to become more conservative over time. However, target date funds are not guaranteed to be risk-free or provide a certain return, but rather to create a diversified, carefully managed, exposure to investment risk, the goal of which is to generate income for retirement.

Background
Recently, TDFs have emerged as an increasingly attractive way to invest money for retirement. These funds began to gain significant traction in 2006, when Congress ruled that companies could make them the automatic choice for employees who did not specify where they wanted their 401(k) savings invested. Following this ruling, the Department of Labor published a set of final Qualified Default Investment Alternative (QDIA) regulations on October 24, 2007, which limited the ability of investors to default to investing in a stable value or money market fund for retirement. In light of this change, the Department of Labor listed three alternatives for investing for retirement:

• Balanced Funds
  
  • Pros: Should provide reasonable diversification and help reduce overall portfolio volatility
    
  • Cons: Often a static asset allocation that may not adjust depending on market conditions, nor will it adjust based on an individual investor's evolving objectives or constraints
    
• Target Date Funds
  
  • Pros: Provide a changing asset allocation along a set age-based glide path, reducing portfolio volatility and generally generating more income as the investor gets older
    
  • Cons: Allocations will not change due to an individual investor's unique objectives and constraints above and beyond the change in age and time horizon
    
• Managed Accounts
  
  • Pros: May provide the ability to actively manage asset allocation based on market conditions. They may also be able to adjust asset allocations according to the investor investor's unique objectives and constraints including time horizon, risk tolerance, and income needs. Managed Accounts may also provide additional services, and allow the investor to develop a relationship with their investment advisor.
    
  • Cons: Many investors may not be interested in the additional investment management services of managed accounts

In addition, the Department of Labor's ruling protected employers who automatically invested workers' 401(k) money in a TDF if the employee proceeded to lose money, further establishing target date funds an extremely attractive way to invest for retirement.

At the end of April 2009, TDFs had seen $13 billion in new net cash flow, a significant increase from the $42 billion of investment that the funds saw in 2008, as well as the mere $4 billion invested in 20021. Currently, there is $176 billion invested in target date funds, and many anticipate that this number will only continue to grow.

Understanding Glide Paths
Although they have been marketed to investors as a simple and low-maintenance way to invest for retirement, it is evident that there are many caveats that must be understood prior to investing in a TDF. A key aspect of TDFs is the glide path: how the asset allocation changes over time. The graph below shows three different target date funds and their glide paths; as the investor ages, the equity allocation of the fund decreases, becoming a more conservative investment as the investor approaches retirement.

While this may seem relatively straight forward, there are two important things to keep in mind when evaluating a glide path. First, many glide paths continue to adjust the fund's equity exposure after the target date is reached. Second, some TDF providers actively manage asset allocations along the glide path within a tactical range, which is determined by current market conditions. In addition to understanding the variety of ways that a glide path can be constructed and managed, it is also imperative to understand the meaning of the date in a TDF's name. In the majority of TDFs, the date refers to when a "typical" investor in that fund would reach retirement and stop contributing to the fund, rather than when they would cash out2. Thus, TDFs are meant to be held beyond the presumed retirement date and are managed for post-retirement needs.

TDFs in 2008
Despite their negative returns in 2008, TDFs performed the way they were designed to; older investors were exposed to significantly less risk than younger investors, and therefore experienced smaller losses during last year's financial collapse. For example, last year the S&P 500 Index returned about -37%, while the Wells Fargo Advantage Dow Jones Target 2010 Fund (WFCTX) returned about -11%, and the same family's 2050 Fund (WFQGX) returned about -36%; the performance of the 2050 fund, which has a higher equity allocation, was closer to that of the S&P 500, while the more conservative 2010 fund lost significantly less than the index3. This example clearly demonstrates that the variety among TDFs in asset allocation, sub-asset allocation, and implementation strategy, allows investors to pick the fund that is the best fit for their risk tolerance, personal situation, and retirement schedule. Historically, a higher equity exposure has the potential to generate larger returns, but these higher potential returns are accompanied by an increased level of risk that must be assumed. From 1926-2008 the broad US stock market returned 9.7% annually, while the overall US bond market returned 5.5% annually, resulting in an equity-return premium of 4.1%. This demonstrates that more aggressive portfolios (higher equity allocation) have the potential to generate higher returns in the long-term; however, to reap these benefits, investors must be willing and able to withstand short-term volatility like we experienced in 2008. Therefore, it is important to both understand and take into account the differences in asset allocation and implementation strategy when choosing a TDF, as these factors directly contribute to the amount of risk that investing in the fund requires an investor to assume.

The Shortcomings of TDFs
As discussed above, we do not view 2008 as a death blow to TDFs. Where we do feel TDFs fall short, however, is in disclosure, transparency, and investor education. The above discussion of glide paths and the true meaning of the target date is just one example of how TDFs may be more complex than they appear on the surface. The differences among TDFs can have an enormous impact on an investor's retirement saving plan, making lack of understanding and disclosure the biggest issues surrounding them. Lack of disclosure has prevented investors from clearly understanding how the fund operates, as it can be difficult to find a true, detailed breakdown of funds' glide paths, a decent discussion of the risks involved and the fund's investment philosophy, an explanation of the meaning of the date in the funds' name, a record of deviations from the stated allocation (tactical allocation), and a clear description of the fund's expenses. In addition, a recent study by Janus showed that 40% of investors select the year of the fund based on when they expect to leave their current employer, not necessarily retire, and 20% believe that TDFs provide pension-like guarantees4. Neither of these are true, which helps explain why TDFs have developed the reputation that they fail to clearly provide much of the information that is necessary for responsible investing. We believe TDFs could benefit by doing more to clearly articulate their goals and processes, ensuring that the investor understands the characteristics and objectives of the investment that they are making.

Conclusion
In conclusion, TDFs provide a simple way for people to invest their money for retirement. While there is always a chance of losing money, the balanced and diversified asset allocation of a TDF should help insulate investors against substantial losses over time, and hopefully generate positive returns in the long run. The key to successfully investing with TDFs centers on the investor understanding the characteristics of the fund, as well as how its glide path changes over time; at this point, it is up to each investor to employ this information and pick the fund that is most appropriate for their financial situation and risk tolerance. However, this can be quite difficult, which is why some choose to invest their money in a managed account at a firm like Kobren Insight Management. Investment advisors can help investors better understand what risks they can take, as well as sift through the enormous amount of data that is available to generate unique investment opportunities that are specific to that investor. Thus, while target date funds are a great way for an investor to take an "auto-pilot" approach toward preparing for retirement, there are certain benefits that cannot be obtained in the absence of active management, making investing in a managed account an equally attractive option for long-term investors.

-- David Lebovitz, Research Analyst

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(Footnotes)
1 “Target Date Fund Joint Hearing before the Department of Labor and The Securities and Exchange Commission.”
http://www.idc.org/pressroom/speeches/09_target_fund_tmny
-- June 18, 2009.
2 “Frequently Asked Questions About Target Date or Lifecycle Funds.”
http://www.ici.org/faqs/faqs_target_date
-- June 2009.
3 Data taken from Bloomberg, August 4, 2009.
4 “New research shows widespread misunderstanding of target-date funds by define contribution plan participants.”
http://image.exct.net/lib/ff021270746501/d/1/Target%20Date%201-page%20Highlights_Advisor_exp03.30.10.pdf
-- April 2009.