Target Date Funds: A Date With Disaster?
By: Patrick Walsh
Patrick Walsh, of SEI Investments, thinks the complex nature of human beings makes easy solutions, such as target date funds, inappropriate for retirement saving.
Several factors, including the increasing risks of sponsoring a Defined Benefit pension plan, have created a trend to increased use of Capital Accumulation Plans (CAP) as the preferred retirement income benefit offered by employers. These plans, however, present their own risks to employers.
Our research1 has shown that fewer than half of all CAP members have ever used the educational and decision-support systems provided by their employer. As a result, sponsors run the risk of having excessive numbers of plan members in their default option and potential litigation over their failure to provide an appropriate education and retirement process.
In response, consultants, sponsors, and investment managers have focused on asset allocation as the solution to the sponsor’s risk management need. Providing a range of asset allocation solutions, and an asset allocation based default, are key to future member success.
There are a range of such asset allocation approaches. These include:
- traditional balanced funds offered by a single manager
- funds of funds assembled by insurance companies
- lifestyle funds offered by managers-of managers
- so-called ‘target date’ funds from various vendors
Traditional balanced funds deserve very little consideration. They represent a single firm’s thinking on a returns-based approach and do not offer a member driven dimension.
Funds of funds assembled by insurance companies attempt to be a ‘look-alike’ to genuine lifestyle funds. Using whatever component funds are currently on the company’s record-keeping platform, they typically offer a range of equity/fixed income asset allocations, implemented using available asset class funds with attractive track records, with a special eye to the insurance company’s own products. They lack risk control, active manager management, and integration with the sponsor’s member education program.
Asset allocation funds represent a manager’s best thinking for CAP members. They offer a wide range of asset allocation choices which provides every member with an appropriate choice. Investments are implemented through third-party managers chosen for their specialist expertise.
The balance of this paper addresses the introduction of so-called ‘target date’ funds as alternatives to these established choices.
At Its Most Basic
At its most basic, a target date fund promises the ultimate in simplicity. If a plan member chooses to invest in a specific fund, presumably with a ‘target date’ close to the members’ expected retirement date, he/she can remain in the same fund until maturity, and the fund manager will adjust asset allocation and perhaps other investment factors progressively as the investors move toward their target date.
It’s not that simple. If it were, who would resist ‘set and forget?’ Unfortunately, human beings are rather more complex organisms than might be assumed by an approach focused only on a worker’s expected retirement date. Essentially, this is one dimensional, but people aren’t.
In order to direct a member to their current appropriate asset allocation, a process of ‘client discovery’ is required. This process should help the member identify their personal life goals and the investment choice that will help them achieve their goals. Yet the target date approach denies this, assuming that a one-factor model (retirement date) will explain all. It is important to recognize that several other dimensions exist. In addition, the liability associated with limited investment choice has also not been clearly addressed by the legal system. This could be of concern for sponsors who only select target date funds.
One of these other dimensions is psychographic.
Right To Change
Assume, for example, a 30-year-old male who states his expected retirement age is 65. The system places him in a fund that is currently 80 per cent in stocks. What this system fails to ask, however, is how this employee will respond if he loses one third of his money over the next two years. As history shows us, this is not an uncommon event. (CF. 1973-1974, 1981-82, 2001 etc.) Over the next two years, the member continues to have the right to change his investment choice. If his response at age (now) 32 is to put everything in a money market fund for the rest of his career, this approach has served him very badly.
In other words, ‘set’ can’t be done based on just one fact.
But, perhaps even more importantly, ‘forget’ doesn’t work either. Here you are essentially making a convenient, but glaringly false, assumption that people’s lives are static. A non-exhaustive list of factors requiring change might include:
- Leaving the workforce to raise children
- Illness to member or spouse
- Special needs child
- Second family formation
- Change in spouse’s career/financial situation
- ‘Winnings’ (insurance, inheritance, lottery)
- ‘Losings’ (business failure, bankruptcy, divorce)
What this means is that the member’s personal goals will change. Only a goals based investment approach will identify and incorporate these changes on a continuous basis.
At a more technical level, we also observe that the actual execution of asset allocation decisions within ‘target date’ funds is poor. Looking at a variety of such offerings, it is clear that as a group, they are systematically under-invested in equities. This under-investing will result in significantly lower retirement savings.
Recognizing that the actual operating experience of the pension industry tells us all that plan members are living longer than ever, increasing their retirement income needs. So why are equity allocations so low? We postulate that ‘target date’ providers have a business priority to retain accounts in the shorter term by minimizing the potential scope of short term investment value declines. This can be accomplished by the use of higher fixed income allocations, but at the expense of increasing the likelihood of failing to meet the investor’s retirement income goals. In other words, keep the investor sweet now, knowing he/she will be unhappy later. Failing to deliver even the limited promise of this product disqualifies it from serious consideration by informed sponsors.
For the simplicity offered by target date funds, members may end up paying a huge price in the form of a poor retirement. Is the trade-off worth it? Target date funds should only be considered by plan sponsors who are convinced that their plan membership is completely beyond their reach. How many sponsors will accept that risk?
Lifestyle funds, by contrast, teamed with their multi-dimensional ‘client discovery’ process, offer the investment approach that long-term investors require to meet their goals. With proper governance of the investments, sponsors have more time to devote to their communication efforts and, with better member engagement, a better result for plan members will follow.
Patrick Walsh is president of SEI Investments.
1. SEI DC Research 2004 has shown that fewer than half of all CAP members have ever used the educational and decision support systems by their employer.
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