When you hear the word ‘target,’ you may picture a specific point in the center of a group of concentric circles. The target doesn’t move, and it doesn’t change shape. Is that the picture in your mind when you think of a target date fund? If it is, you’re not alone. A target date fund, to most people, invests toward a fixed point at or near retirement, investing aggressively in the early years and getting more and more conservative as the target date nears.
That makes perfect sense. Unfortunately, it isn’t always the way it works.
In general, target date funds set an endpoint, or target, of the investor’s retirement age. They are often designed with 5-year intervals, and the investor chooses the fund closest to his or her retirement date. For example, a participant born in 1943 would reach age 65 in 2008, so he or she would likely be invested in a 2010 fund.
Target date funds have gained popularity in the last several years for at least two reasons. One is the simplicity of the idea. Investors who don’t feel confident in their own investment acumen can simply park their money and feel relatively confident that it will be there when they need it.
The other reason lies in the Pension Protection Act of 2006 (PPA). One section of the PPA sought to protect participants from their own failure to make investment decisions. Prior to the Act, plan sponsors often invested undesignated accounts in a money market fund, where it was safe but earned little interest. The PPA allowed plan sponsors, under certain conditions, to invest the funds in a target date fund instead. Returns improved, plan sponsors and Congress felt better, and everything seemed fine.
Then the stock market crash of 2008/2009 revealed a couple of problems.
Problem #1: Investing Too Heavily in Stocks as Distribution Date Approaches
The theory behind target date funds is sound: invest aggressively in the early years, and gradually move out of the stock market into more conservative investments as retirement nears.
In practice, though, flaws came to light. Definitions of the words aggressive, conservative, and even target are inconsistent from one fund manager to the next. That can mean tremendous differences in the ultimate returns from the funds, and even their safety.
Why? Joe Nagengast of Target Date Analytics (www.ontargetindex.com) explains that as the stock market climbed early in the 21st century, fund managers began to realize that they could demonstrate large returns—therefore selling more investments—if they invested more heavily in the stock market.
“Let’s say you and I are both managing 2010 funds, it’s a few years away from 2010 and the market is going through the roof,” he illustrates.
“You have 80% equities in your 2010 fund, and I don’t believe that’s safe, so my 2010 fund only has 10% equities. You’re going to go out on your road shows and client proposals and show them, ‘look, we’ve got 40% growth in our 2010 fund and Joe only has 5% growth in his.’
“That’s fine as long as the stock market is going through the roof. But when things go bad, as they did, who gets hit harder? Your funds do, but as a manager, you don’t bear the loss; your participants do, and their retirement accounts are destroyed. That’s what happened.”
Problem #2: ‘To’ vs. ‘Through’
David Hand of Hand Benefits & Trust (www.bpas.com) calls on Target Date Analytic’s (TDA’s) expertise in target date investing. “From a fiduciary standpoint, we feel like we are acting in the best interests of the participants if we give them a fund that gets them to retirement safely,” Hand says. Notice that tiny word: to. Hand and TDA are big believers that a target date fund should invest so that retirement funds are intact when the participant reaches retirement age. While that may seem obvious, many fund managers set the target farther into the future. Because people often live for decades after they retire, they believe the funds should maximize investment returns for as long as possible.
That is the crux of the target date issue: should target date funds invest to retirement, or through retirement?
The advantage of a ‘To’ fund, according to Hand, is that most plan participants tend to take a distribution at retirement. “In our client base there are very few participants over the age of 65 who have an account balance in their plan,” he says.
“In fact, there are a great number in our client base who take a distribution before they really retire. They may work part time for the company, or some other work/life arrangement,” he explains.
“But even those folks tend to take their money out of the plan. We are very big proponents of TDA’s ideas, among them that participants’ idea of a conservative fund is to have very little invested in equities (as retirement nears). That’s probably the perception most people have of what a target date fund was designed to do.”
A ‘To’ fund seeks to preserve as much of the retirement account as possible when the person retires, even when the economy suffers as it has in recent months.
The advantage of this kind of thinking is obvious when one takes a glance back at the last year.
“A 2010 ‘To’ fund would be designed to have so little invested in equities toward the end that a participant would have had very little exposure to the market, and would have missed all the problems in 2008 and 2009,” Hand says.
“A 2010 ‘Through’ fund, on the other hand, would say that at age 65, a participant should have 40% or 50% invested in equities. As such, they would have suffered substantial market losses.
“On June 18 of this year, there were Congressional hearings, in which Joe testified, and that was new information for some at the departments of Labor and Treasury and Congress.
“Of all the 2010 target funds, there are only 11 providers with more than 10 years’ experience with target date funds. That’s not a big track record.
“Testimony before Congress showed that some of the 2010 target funds had 62% in equities and some of them had 24% in equities while the Hand Benefits & Trust 2010 SMART Fund®, managed by TDA, had less than 10%. That’s a huge disparity, and a huge disparity is a risk.
“The average loss in 2010 funds in the last year was 27% and the high was 46%. The problem is that it’s virtually impossible to recover from that loss unless you put more money in. The only alternative for most people is to keep working if they want to make that up.”
A final word of caution from Hand: If the only reason you offer a particular target date fund is that it comes along with your recordkeeping services, be cautious.
Ask about the investment mix and the ultimate target for the funds.
If you’re uncomfortable with the answers, your responsibility as a fiduciary may mean you’ll need to make some changes.
Remember, all target date funds are not created equal.