SEC recommendations about the inherent risk of target date funds are more controversial than their author's realize, says a veteran risk assessor
Brooke’s note: Nutrisystem, based on TV ads, is a very effective way to lose weight. Famously tubby people have paid, cumulatively, hundreds of thousands of dollars to have the little boxes mailed to their houses and lose weight long enough to shoot a commercial. They’re still not exactly slim but back to a mediocre range. So sometimes advice and discipline delivered in a box delivers. The knocks on Nutrisystem relate to the fact that the system’s user may still have several boxes of cookies open in the pantry — or an advertising contract to induce added discipline. There are other issues like the fact that Nutrisystem is more about losing weight and not maintaining weight. Robert Boslego — a Harvard man and graduate of Stanford who has more than 20 years’ experience in developing and providing price risk analysis and hedging strategies for major corporations — seems to have sensed a certain set of related product deficiencies in target date funds. He’s not alone. The SEC has cast a leery eye on TDFs since the ’08 crash and recently offered guidance. All well and good, but the guidelines do not go nearly far enough. And that’s where Boslego comes in.
Target date funds are experiencing rapid growth as baby boomers approach and enter retirement, growing by an average of 30% per year (see Exhibit 1). The target date fund market totaled approximately $485 billion in assets at the end of 2012 and is projected to exceed $1 trillion in four more years.
Usually, one would expect a retail product in a fast-growing, $500 billion market to have a great reputation among the consumers buying the product and the professionals who provide, recommend and sell it. The odd thing here is that its growth may be largely attributable to ignorance. Most owners of the product don’t understand basic, important features of what they own. See: What the alternative is to ill-conceived Target Date Funds.
The Securities and Exchange Commission has been trying to change that. Following larger losses than would be expected of target date funds in 2008, it proposed new rules in 2010 and adopted recommendations of its Investor Advisory Committee in 2013. IThe Commission wants investors to understand the products and their risks.
In this article, I explain how this happened and present the kind of risk analysis I think the SEC wants people to see. I believe that the ultimate solution for investors is risk-managed strategies to fit their circumstances and appetite for risk. See: First, own all the risk.
Default options and the Pension Protection Act of 2006
Behavioral economists have learned two important lessons from researching how people make choices: Never underestimate the power of inertia, and that that power can be harnessed. Research shows that whatever the default choices are, many people will stick with them.
The Pension Protection Act of 2006 was designed to increase saving for retirement by including a powerful default option: automatic enrollment of employees in retirement plans, unless they opt out. Once people are automatically enrolled, a second default option is required: how to invest their money. The Labor Department developed four default options and qualified default investment alternatives were legislated into law in 2007. The most popular QDIA became target date funds, selected by about 70% of employers. See: Experts open playbook on retirement plan reform.
Target date funds are portfolios that are designed to address a variety of risks faced by individuals investing for retirement: investment risk, inflation risk and longevity risk. Balancing these risks involves trade-offs, such as taking on greater investment risk in an effort to increase returns to reduce the chances of outliving one’s retirement savings. The way different financial engineers make these trade-offs can vary greatly, resulting in large differences in risk and return. Many assumptions are needed about a person’s other investments, income, needs and appetite for risk to make such calculations relevant to anyone.
Target date funds are designed to become less risky by changing their mix of assets (usually stocks and bonds) as the “target date” (i.e.,. expected retirement date) draws nearer. For example, the fund in Exhibit 2 holds 60% of its investments in stocks at the target date and 40% in bonds. The investment in stocks decreases until 25 years after the target date when it reaches an investment mix with 30% in stocks and 70% in bonds.
The expectation that bond holdings will provide low risk may not prove out. Bond yields have been in a 30-year decline to very low levels and may move higher when the Fed stops buying them to keep yields low. Bond prices fell sharply in May and June at the prospect that the Fed might taper its bond buying later this year. See: Meredith Whitney blames ’60 Minutes’ for her muni 'call,’ then doubles down on the 'hell’ coming for muni bonds.
The shock of 2008
Target date funds suffered significant losses in 2008, and there was a wide variation in returns among funds with the same target date. Investment losses for funds with a target date of 2010 averaged nearly 24% in 2008, ranging between approximately 9% and 41%. The three largest issuers of such funds extended their losses to between 32% and 37% in March 2009, less than 10 months prior to the retirement target date (see Exhibit 3).
The dramatic drop in value of target date funds that were close to reaching their advertised target date brought new attention from the SEC. One study conducted in 2010 found that such funds exposed investors nearing retirement to a significantly higher maximum potential loss than most pension consultants surveyed deemed appropriate. At the same time, almost two-thirds of these pension consultants assumed that they were invested more conservatively than was in fact the case. See: 10 essential steps that 401(k) plan sponsors need to take in 2013 to put clients on the right road to retirement.
Target date fund names and marketing
The SEC staff reviewed a sample of target date fund marketing materials and found that the materials often characterized such funds as offering investors a simple solution for their retirement needs. Even though the marketing materials often included some information about associated risks, they often accompanied this disclosure with slogan-type messages or other catchphrases encouraging investors to conclude that they can simply choose a fund without any need to consider their individual circumstances or monitor the fund over time.
In 2010, the SEC proposed a rule that would:
• Require a target date retirement fund that includes the target date in its name to disclose the fund’s asset allocation at the target date immediately adjacent to the first use of the fund’s name in marketing materials.
• Require marketing materials for target date retirement funds to include a table, chart or graph depicting the fund’s asset allocation over time, together with a statement that would highlight the fund’s final asset allocation.
• Require a statement in marketing materials to the effect that a target date retirement fund should not be selected based solely on age or retirement date and is not a guaranteed investment, and that the stated asset allocations may be subject to change.
In 2012, the SEC sponsored a study to assess investors’ understanding of target date funds, which yielded significant findings:
• Only 36% of respondents corrected answered a true-false question asking whether target date funds provide guaranteed income after retirement, the correct answer being that they do not.
• The top reason respondents gave for choosing target date funds was “it seems like a safe investment for retirement.” See: Why the industry needs to accept some blame for 'flaws’ in PBS Frontline’s 'Retirement Gamble’.
When people who own target date funds retire, data show that about 70% of them sell them within three years. For example, Fidelity Investments’ 2010 fund had $11.1 billion in assets as of March 31, 2010, and those assets declined to $5.9 billion as of March 31, 2013. One hypothesis is that retirees soon learn that their target date fund does not provide the guaranteed income many of them expected. And then they see that their principal is exposed to greater risk than they want. See: Fidelity brings its 401(k) muscle to RIAs with new product.
'Something really important’
On April 11, the SEC Investor Advisory Committee asked the commission to expand its 2010 proposed rule. The SEC adopted its four recommendations:
The commission should develop a glide path illustration for target date funds that is based on a standardized measure of fund risk (see Recommendation 2) as either a replacement for or supplement to its proposed asset allocation glide path illustration.
The commission should adopt a standard methodology or methodologies to be used in both the risk-based and asset allocation glide path illustrations.
The commission should require target date fund prospectuses to disclose and clearly explain the policies and assumptions used to design and manage the target date offerings to attain the target risk level over the life of the fund.
The committee strongly supports the commission proposal to require target date fund marketing materials to include a warning that the fund is not guaranteed and that losses are possible, including at or after the target date.
One committee member, James K. Glassman, who is also the founding executive director of the George W. Bush Institute at the new GWB Center in Dallas, was quoted as saying: “We are actually going to teach investors something really important that most of them do not understand.”
Shortcomings in the SEC’s recommendations
The SEC has made no indication regarding the timing for preparing a concrete new rule proposal in response to the committee’s recommendations. As I explain below, this may prove difficult. However, I’d like to contribute some ideas on how this might be done.
I have more than 20 years’ experience in developing and providing price risk analysis and risk management (hedging) strategies for major corporations. I was selected by the former president of the New York Mercantile Exchange to write the chapter on hedging in his book, Energy Futures, for both the 1990 and 2000 editions.
The committee recommended that the risk definition “should focus on factors such as maximum exposure to loss or volatility of returns that are directly relevant to the primary concerns of those approaching retirement.”
The committee’s stated goal is to ensure that the new information that it wants target date funds to provide is an accurate and easily comparable depiction of fund risk, objectively measured, not easily gamed, and sufficiently flexible to apply to different methods of managing risk to allow for continuing innovation among target date funds. See: Dimensional Fund Advisors tells RIAs it’s getting active in its quest for 401(k) assets.
SEC Commissioner Daniel Gallagher has said that the recommendations are noncontroversial. Unfortunately, portfolio risk assessment is a complex subject, and the stated goals are not easily achievable, especially when firms apply different methods of risk management, which can produce very different outcomes. I think this could become quite controversial.
In addition, there is no mention of providing expected returns. On the one hand, I understand why the SEC would not want target date funds to provide that information. On the other hand, how can an investor decide whether the risk is worth taking, or which target date funds offer the best trade-off between risk and return, if all that is provided is risk? Future “maximum exposure to loss” is difficult to predict and would be misleading to investors if larger losses actually occur than are predicted and “volatility of returns” is too abstract and does not tell people approaching retirement how much they can lose.
Risk glide paths
I think a better choice is “maximum likely loss.” This definition would state a maximum likely loss in percentage terms based on a low historical frequency for a specific holding period of the portfolio. It would also include the loss of purchasing power due to inflation. Finally, it would be adjusted to include the fund’s “basis risk,” which is the risk or deviation of its performance versus market benchmarks, based on the fund’s allocations and risk management practices.
The benefit of using historical frequencies is that they are known and are objective measures of gains and losses. The downside is that future risks may be larger than the losses of any past period and may be more frequent.
To provide an example, I based my calculations on annual stock (S&P 500) and bond (10-year Treasury) market returns from 1928 to 2012. I selected a 1% historical frequency of maximum loss for five-year holding periods. See: With inflation on a tear, 401(k) plans look vulnerable and BrightScope publishes a cheat sheet.
I also assumed a 3% annual inflation rate to calculate the loss in purchasing power. My calculations do not include any basis risk, which introduces a lot more complexity to the calculations.
To construct the risk glide paths, I used the stock/bond/cash assets allocations as of March 31 for each of the three largest target date fund groups (Vanguard, Fidelity and T. Rowe Price) for their 2015 through 2045 offerings. I used these as proxies for the change in allocations from less than five years (2015) to less than 35 years (2045) until target dates are reached. See: John Bogle tells the Morningstar crowd just why Vanguard Group has a 'problem’ — and it starts with his dogged criticism.
The maximum likely losses reveal very high potential losses for relatively close target dates, from 34% to 41% for 2015-dated funds, and from 37% to 46% for 2020-dated funds (see Exhibit 4). In addition to the loss of principal, these include an expected loss of purchasing power of 16% (for a five-year holding period) due to inflation.
Proponents of Modern Portfolio Theory say not to worry about such “paper losses,” keep invested in stocks for the long run. But, as John Maynard Keynes is quoted as saying, “The long run is a misleading guide to current affairs. In the long-run, we’re all dead.” See: Why the Yale endowment model may still be fundamentally flawed.
There is no guarantee that stocks will recover from a major loss within the time frame the retirement money is needed. Consider an investor in Japan in 1989, about to retire. Remaining in equities would have produced a “paper loss” of around 80% over the subsequent 20 years. The investor may literally die waiting for his or her portfolio to recover.
Even as 2013 has been (to date) a breakout year for major stock markets, with the recent rally taking U.S. equities to record highs, UBS group chief executive Sergio Ermotti recently said risk aversion among the bank’s clients is at the highest ever seen in the industry. “Clients’ remain … almost paralyzed, [with a] very high level of cash balances. And this has been the case for the last seven quarters,” he said.
Risk management of target date funds
Investors in target date funds are, in effect, relying on the fund manager’s asset allocation model, which may or may not be appropriate for any particular investor’s situation. The model’s assumptions may be inappropriate — either from the outset or as a result of a change in the investor’s economic or other circumstances, such as job loss, unexpected expenditures that lead to decreased contributions, or serious illness affecting life expectancy.
One alternative is to risk-manage investments in target date funds. Risk management may provide a more appropriate level of risk for any particular investor’s circumstances and appetite for risk.
Taking lower risk is generally expected to produce lower returns. Major corporations hedge their risks because they want to stay in business, and fund their operations and projects. The same logic could apply to individual investors. The often-repeated phase that “market timing doesn’t work” applies to beating market returns. That’s not the goal here.
Effective risk management may, in fact, produce higher returns. That is the nature of risk. Taking higher risks does not necessarily produce higher returns.
For an example, I applied my risk management strategy, vertical risk management, to one target date fund, Fidelity Freedom 2015 (FFVFX), in a back-test from 2003 to 2012. Vertical risk management creates systematic strategies to apply to portfolios. The objective is to reduce maximum losses to more acceptable levels by reducing investment at times in the fund, and then increasing investment. See: Why the Yale endowment model has potentially calamitous pitfalls according to … Yale itself.
The result of applying the strategy to FFVFX was to reduce the maximum drawdown loss from 39% to 8%. Because the strategy avoided a major drawdown (see Exhibit 5), it produced a better total return, up 79% versus 69%. (Important: these are hypothetical results based on a simulation.)
Target date funds have become a major manager of retirement funds in the United States, and they appear likely to continue growing rapidly, but not necessarily for the right reasons.
The SEC wants to make them more risk-transparent, but that is a tall order because risk is a complex topic. It makes a lot of sense to shift fund descriptions from a retirement date and allocation to a risk profile that includes potential loss estimates, not marketing slogans.
The best way investors can be served is by receiving more customized solutions attuned to their circumstances and risk preferences. I believe that risk management can provide a more satisfactory solution. With Internet services evolving, and Internet- and computer-savvy baby boomers aging, it is becoming possible to reach millions of average investors with more-customized solutions to provide more-satisfying results.
Robert Boslego is managing director of Boslego Risk Services, a consulting firm in Santa Barbara, Calif. He earned a Bachelor of Arts degree cum laude in economics from Harvard College and an MBA from the Stanford University Graduate School of Business. Contact him at Boslego@Boslego.com.