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The set-and-forget products have enormous potential for good but may also be a fiduciary nightmare
March 21, 2014 — 4:29 PM UTC by Guest Columnist Jacob Adamczyk
Brooke’s Note: This article won the 2013 FI360 contest for the best piece written on a matter related to fiduciary care in the financial advisory business. For some reason this wonderful, timely, thought-provoking essay has yet to run in a publication — and so, here it is. Incidentally, FI360 is again hosting this contest and entries will be accepted until mid-April and RIABiz is helping to judge the entries and award the $1,000 prize. Experts are great but as this essay shows, it takes an advisor to really get at the nub of the issue — what works for the client.
When it comes to target date funds, people tend to love 'em or hate 'em.
The product group is certainly lovable for its ability to pump out a level of set-it-and-forget-it management of 401(k) holdings executed under branded, professional guidance. See: Jim Lauder rebuts RIABiz article on the failure of target date funds.
Yet target date funds are certainly open to criticism, too, because their implicit promise of being a magic bullet with a Sully Sullenberger-like command of glide path does not seem to bear itself out in reality. See: Why target date funds fail in the one area they’re supposed to succeed — downside protection.
Into this polarized set of viewpoints I step as a financial advisor. I can’t make bold proclamations from an ivory tower. I need to manage people’s nest eggs as a fiduciary based on the products and knowledge at my disposal, and do so within economic restraints related to account balances great and small.
Target date funds are better than nothing and they are flying off the shelf because they solve an enormous problem putting 401(k) participants’ assets in a simple diversified fund with a rudimentary mechanism for rebalancing — which most people agree is better than having those funds go without any management or investment at all.
Time to rethink
But there are many things advisors, regulators and employers can do to make these target date funds so. If the industry doesn’t start to make changes, then it better brace itself because the Department of Labor is prepared to start issuing rules.
It is time to rethink how target date funds operate within qualified retirement plans. At their core, if defined contribution plans are going to be the lifeblood of American retirement, they must be prudent, conflict-free and transparent.
Right now, target date funds aren’t always prudent, some of them are filled with conflict because they are stuffed full of proprietary funds selected by the fund company — if the underlying investments can be determined at all. Of course, these are many of the same criticisms leveled against fund lineups in conventional 401(k) plans so movement of those funds to target-date products amounts to a shell game.
Shining a spotlight
It behooves us as fiduciary advocates to lead the movement to make these target date funds successful in the long run by aggressively throwing light on their wrongheaded or simply misunderstood elements. See: After 'a lot of flak’ Fidelity Investments does a study and pledges to change how it manages its $170 billion of target date funds.
For the most part, people don’t understand 401(k) plans so the issue of raising awareness of target date funds is particular daunting. The issue is one of raising awareness. Many participants still don’t understand that they’re taking a risk when they purchase target date funds and that these aren’t guaranteed funds. Another big problem with these funds is many employers aren’t vetting the target date funds because they assume they are all the same. See: What led to Vanguard allowing its 401(k) plan sponsors to shop around for non-Vanguard target-date funds.
That assumption couldn’t be farther from the truth.
The popularity of target-date funds blossomed when Congress passed the Pension Protection Act of 2006, which made a number of changes to the way retirement plans are handled. One of the biggest changes was setting up automatic enrollment within qualified retirement plans. See: Big chill: Worried RIAs and other 401(k) leaders gather in Chicago in hopes of saving the goose.
The Department of Labor later issued an advisory opinion defining what investments could qualify as default investment alternatives. Qualified default investment options are the investments that participants/employees could be defaulted to if they fail to make an investment selection themselves. Plan sponsors are required to use strict standards in choosing the default option.
For instance, the Department of Labor decided that three types of investments were OK to be used — lifecycle and target date funds, risk-based/balanced funds, and model portfolios — of which target date funds quickly became the most popular choice.
Unfortunately, at the time the pension protection legislation was passed, there was a paucity of regulation regarding the due diligence and monitoring of target date funds. Making matters worse for investors was the timing of the 2008 financial crisis which caused many target date funds, even those with the nearest target date, to post significantly negative returns. See: Jim Lauder rebuts RIABiz article on the failure of target date funds.
Land grab or epidemic?
A recent study by the Employee Benefit Research Institute found that the percentage of recently hired (less than two years at the current employer) 401(k) participants that chose target date funds steadily increased from 28.3% in 2006 to 47.6% in 2010. The statistics are even higher for younger workers: Among recent hires in their twenties, over 52% chose target date funds in 2010, according to Chicago-based Morningstar Inc. data. Morningstar estimates that in each year from 2006 to 2010, every category of target date funds enjoyed positive inflows.
To see how frothy target date fund usage has become, simply consider that in 2008, total assets for all target date funds were $160 billion; a mere three years later, total assets swelled to over $378 billion by 2011, according to Morningstar data. In 2012, the target date fund assets hit $485 billion and as of 2013, the assets had jumped to $621 billion.
During the worst financial recession since the Great Depression — with investors repairing their balance sheets by spending less to pay down debt and companies eliminating discretionary matching contributions — the target industry experienced 136% growth, an annualized growth rate of over 45%.
Higher level of scrutiny
Recently, the Department of Labor released a bulletin outlining important questions and due diligence requirements for plan sponsors to contemplate as they evaluate their plans’ target date funds.
That means plan sponsors must actually monitor the target date funds in their respective plans. Unfortunately, many don’t monitor them. Most plan sponsors do not perform an equal amount of due diligence on target date funds as they do with other investments. See: One-Man Think Tank: Would your investment strategy stand up in court?.
The reason they don’t complete a high level of due diligence is because it is simpler to choose the bundled provider. For example, the target date series is part of the packaged deal. Plan sponsors assume the target date series is satisfactory as long as the provider remains solvent — a thinking annuity holders may be more justified in feeling.
But there is an important nuance employers need to understand about target date funds. Because they usually serve as the qualified default option, there is an extra level of fiduciary duty the plan sponsor must fulfill. In other words, employers need to give these target date funds even closer scrutiny than other funds.
Fiduciaries on notice
Plan sponsors should be giving appropriate consideration to the facts and circumstances that it knows to be relevant to the target date fund series, including the role that target date funds are intended to play inside the 401(k) plan. See: What led to Vanguard allowing its 401(k) plan sponsors to shop around for non-Vanguard target-date funds.
What is especially noteworthy of the DOL’s bulletin is that, for the first time it has put in writing that ERISA fiduciaries must evaluate the risks of target date funds on an absolute basis, not just on a relative basis against other target date fund families.
For the first time, the DOL has explicitly instructed employers analyze the risk characteristics of target date funds compared to all other available alternatives, from a large-cap stock fund to an emerging market debt fund. How many plan sponsors have the adequate skills and resources to effectively evaluate their target date funds?
Realistically, plan sponsors will turn to us — fiduciary advisors — for guidance. And that is no small task. For plan sponsors and plan advisors alike, the risks just dramatically increased. The DOL is essentially warning plan fiduciaries, allotting them time to get their affairs in order. See: Phyllis Borzi tightens the noose on 401(k) providers that flout DOL disclosure, not without critics.
We have met the enemy…
First, we must recognize that not all target date funds are created equally. Consider that in 2008, the return performance of 2010 target date fund strategies ranged from -9% to -41%. Yet even with such extreme return dispersion, the reliance upon target date funds in retirement plans is only increasing because more plans are shifting toward target date options.
Broadly speaking, the benefit of a qualified default option such as a target date fund cannot be disputed. Offloading the investment decisions from participants to investment professionals is almost a necessity in today’s world. So few participants have the requisite skills or time to prudently manage their retirement accounts, let alone updating asset allocations or rebalancing.
In fact, studies show that participants who receive some sort of investment guidance — defined as target date funds, managed accounts and/or online advice — experienced, on average, annual returns are 3% higher than those participants who handle their own accounts. Over a 20-year period, this can equate to 69% more money saved in a retirement account. So, in general, target date funds can work because they protect amateur investors from their own worst enemies — themselves.
Burden of proof
However, target date funds present a unique blend of challenges that must be met head on — and sooner rather than later as retirement accounts continue to grow. The supposed benefit of target date funds is the straightforward approach to asset allocation, the ease of use as a “one stop shop” for investing. Again, the “set it and forget it” mentality is theoretically commendable. See: Fidelity counsels RIAs to suck it up and go after 'millionaires of tomorrow’ but with a strict discipline.
But the participant’s choice of a target date funds is completely reliant on the plan sponsor making a prudent decision of the fund provider. This is where the system begins to fail.
Plan sponsors have no means by which to objectively compare qualified default options such as target date funds. And when plan sponsors cannot prudently monitor, the burden of proof shifts to the advisor (assuming the advisor is acknowledging fiduciary responsibility, but that’s a separate discussion).
The predominant issues with target date funds center on the notion of risk management and participant education. Regarding risk management, one can look at the wide range of asset class weightings across different fund families.
Much-maligned glide path
In 2009, even after the horrific financial markets of 2008, the targeted equity allocation for 2010 target date funds ranged from 67% to 26%, while 2050 target date funds ranged from 99% to 84%. A mere two years later, in 2011, the targeted equity allocation for 2010 target date funds ranged from 70% to 20% and the 2050 target date funds ranged from 95% to 38% With such broad ranges, how can a plan sponsor realistically know whether its target date fund series is appropriate? See: Performance measurement challenges for investors who live in a perpetual time horizon world.
One can also look at the much-maligned topic of the glide path. How can someone possibly know today what the correct asset allocation will be in, say, 2050? Without a crystal ball for the capital markets, glide paths are inherently mistaken. They create a predetermined allocation without consideration of market conditions. See: 10 essential steps that 401(k) plan sponsors need to take in 2013 to put clients on the right road to retirement.
Many times, fund prospectuses mandate a minimum-equity weighting; so even if a manager theoretically knew that equities were overvalued and likely on pace for a secular bear market, he could do little to position the fund appropriately. Just as “to” cannot be synonymous with “conservative” and “thru” cannot be synonymous with “aggressive,” glide path cannot be synonymous with “set it and forget it.” One can also look to the rebalancing strategy. Does it rebalance around a strategic or tactical target? How frequently does rebalancing occur? Is the frequency standardized or at the discretion of the managers?
Regarding participant education, there has been no adoption of an industry standard for fund naming and disclosures. This slick marketing has drawn the ire of the DOL and SEC. A recent study submitted to the SEC that showed only 36% of investors correctly indicated a target date fund does not provide guaranteed income in retirement. In other words, 64% of investors surveyed thought target date funds provide guaranteed income. See: How a suddenly wealthy, young Bay Area widow found her RIA after months of fruitless efforts.
Talk about a disconnect between the fund companies and the unknowing investors! If the status quo continues, the informational gap will only widen.
How can plan sponsors effectively choose a target date series when different fund families have different levels of transparency? What about the predominant use of proprietary products? Would a plan advisor (who works for the bundled provider) actually recommend removing its own target date fund series if a due diligence review prompted it?
That’s tough to imagine, even if the advisor acknowledges fiduciary status. Participant education should also include a discussion of the impact of fees on a retirement account over a long-term time horizon. The least expensive target-date-fund family has a weighted-average expense ratio of just 0.18% while the most expensive target date fund family is 1.31%, with an industry average of 0.83%. Low cost does not mean low risk, just as diversification of assets does not mean diversification of risk.
A new purpose for target date funds
The objective of target date funds need to change.
All employees have the same objective: to enjoy a decent retirement. That means the definition or risk needs to change.
Target date funds can’t focus solely on growth and capital appreciation, save for the longest-dated funds with equity-centric allocations. With the majority of target date fund investors age 50+, they simply do not have the longevity to weather the turbulent storms that are the financial markets (i.e. longevity risk). We have older investors — with the largest account balances — taking the same amount of risk as 20-somethings with a few thousand dollars saved for retirement. Investors cannot afford the unnecessary risk of most target date funds. Capital preservation can no longer be an afterthought, for both individual investors and fund companies alike.
Simply put, target date funds need to be liability-driven. Taking a liability driven approach means turning the typical question of risk on its head. Liability driven investing is fairly new in the defined contribution arena, and what it means is focusing more on the risk of not being able to retire. See: How one IBD rep just zoomed to $1 billion AUM — on his way to $2 billion — but remains impervious to calls from RIA custodians.
Liability-driven investing is about dynamically managing risk. It involves the diversification of risk, not just the diversification of assets. Diversification of assets alone is not a sound outcomes-based approach. Risk diversification involves understanding economic cycles, recognizing valuations of different asset classes, and identifying unique strategies that aim to generate a positive return over a market cycle. Effectively diversifying risk exposure involves utilizing a combination of strategies (managers) with a low correlation of excess returns and maintaining liquidity to provide flexibility to take advantage of favorable market opportunities. They key is to be able to tactically shift the asset allocations depending upon market conditions — not blindly following a path that was set under a different economic environment.
Essential conflict of interest
Right now, in the target date industry, there is a serious disconnect between investor assets and an investor’s life expectancy. Target date funds must account for longevity risk by focusing on capital preservation with risk-controlled growth. When planning for retirement, the most important years for most workers are the ten years prior to retirement and the ten years following retirement. This 20-year period often determines the standard of living for the remainder of their lives. As currently constructed, target date funds are only useful during the accumulation phase prior to retirement.
The retirement plan market needs a solution that is right for participants, not the product providers who reap massive assets from these plans. See: An attorney explains where the 'trail goes cold’ in PBS’ 'Retirement Gamble’.
Most target date funds are chosen from bundled service providers that offer a closed-architecture fund lineup with proprietary TDFs simply because they can. And therein lies the conflict of interest. Even if fund companies allow non-proprietary funds in the lineup, the companies often charge higher fees for outside target date funds in the hopes of making up for lost revenues.
Meeting the challenge
These qualified default options must shift from overly aggressive target date funds toward professionally risk-managed portfolios. Target date funds do not manage risk exposure, they instead manage return expectations around a benchmark. We, as fiduciaries, should move toward portfolios that are designed to match the duration of the assets with the duration of the investor. Imagine an investment solution that diversifies not only assets, but also diversifies risk. See: In search of alternative income solutions in the current low-yield environment.
Risk-based portfolios provide a level of clarity to participants that age-based target date funds do not.
No longer can institutional managers, plan sponsors and plan fiduciaries plead ignorance to the outcomes of target date funds. As plan fiduciaries, we have the opportunity to begin to change the misperceptions, to rethink these funds as efficient asset allocation tools that match the duration of the assets with the duration of the investors. Allow participants to choose — or default into — a portfolio based upon more than just their expected retirement age.
Three key factors
Choosing a fund based upon your expected retirement date says nothing about your risk level. Many workers underestimate their retirement date to begin with, and the number of workers is only increasing as government entitlement programs that were once the safety net of an entire generation have now become one of the nation’s largest unfunded liabilities.
At its most basic level, retirement planning involves three factors: longevity risk (will I run out of money?), capital market assumptions (how much will I earn on my portfolio for a given level of risk?) and pay replacement (what will be my annual withdrawal rate/spending?).
How many on these factors do target date funds consider? Typically, they only consider one factor: portfolio returns. Now, this is not to say that risk-managed portfolios meet all three criteria either, because pay replacement is obviously a case-by-case consideration.
But risk-based models certainly take into account the other two factors. Because risk-based models involve matching the duration of the assets (longevity risk) with the duration of the investor (risk tolerance), they allow plan sponsors and plan fiduciaries to more prudently select these types of funds.
The more variables that can be eliminated from retirement planning, the easier it will be for millions of workers. These risk-based solutions currently exist; they just are not mainstream solutions.
RIA Jake Adamczyk is an associate vice president at Aurum Wealth Management Group in Cleveland. His firm began overseeing 401(k) plans a few years ago and manages about $120 million in retirement accounts and about $270 million in wealth management assets. He wrote this column for a contest sponsored by FI360 and won.
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