What the alternative is to ill-conceived Target Date Funds

Elizabeth’s note: The assets in target date funds will grow to $7 billion in 2020, from 2.5 billion in 2005, thanks to a 2007 ruling by the Department of Labor that made the plans one acceptable default choice for employer plans, according to 401(k) research and rating company BrightScope. SEC Chairman Mary Schapiro remains suspicious. In a speech in early February, she noted that she has asked SEC staff to prepare a rule proposal to provide additional information to investors when a fund includes a date in its name. “Not all target date funds are created the same, and some with very near-term target dates lost substantial amounts of investors’ money in 2008,” she said. The SEC aside, Rob Isbitts lays out the reasons to steer clear of target date funds.

Target Date Funds are sold to investors as all-in-one investment portfolios in that they allocate amongst the broad stock and bond markets.

They are designed to adjust the allocation based on how many years remain until the investor’s target retirement date. This is not necessarily the date when the investor will stop working, but it is the date to which the fund is managed.

In other words, the target dates are set with the masses in mind, and the investor may choose a fund that is aiming to reach its objective at a point close to when they expect to use the money.

I believe that for many investors in their pre-retirement years, Target Date Funds are not just a bad idea but a misleading one. As I said above, Target Date Funds allocate money amongst the broad stock and bond markets. But in doing so, they are setting themselves up for failure in two ways.

Disappointed

First, by limiting Target Date Fund investments to traditional stock and bond strategies, the investor has what I would call “correlation risk” – when stocks fall, they tend to fall as a group. That means that the investor, who expects his or her Target Date Fund’s stock portfolio to fall by a modest amount owing to their diversification amongst small cap, large cap, growth, value and international stocks, ends up disappointed.

They are disappointed because the expected benefit of diversification does not accrue to them. Because when markets fall hard, all major categories of stocks fall together. This is what broke so many hearts and so many retirement dreams in 2008 and early 2009. I think that Target Date Funds provided a false sense of security then, and I have seen no evidence that leads me to be any more optimistic now.

In 2008, bonds were a savior to Target Date Funds, as U.S. Treasury Securities surged in value when investors fled to their perceived safety. But that ship may have sailed.

The next stock market decline may not offer a hiding place in high-quality bonds like Treasuries. Why not? Because they are increasingly viewed as not being of high quality anymore! The debt being racked up by the United States and many non-U.S. governments has called the stability of U.S. interest rates into question.

Rates will go up

That is not to say that I think the U.S. Government will default on its debt. I just believe the government will have to pay much higher rates to borrowers to keep the country functioning. When that happens, rates will go up and bond prices go down.

Combine that with a stock market that, while possibly in long-term recovery mode, will not likely advance in a smooth path. The bottom line: a traditional mix of stocks, bonds and even cash may lead many Target Date Fund investors to look back and feel they were mislead by the promise of a “managed” path to retirement.

In order to remedy this, Target Date Funds must look beyond traditional investment styles. They should be willing to incorporate, in a thoughtful and flexible manner, the ability to profit from market declines through shorting and other hedging approaches.

They should also allow longer-dated Target Date Funds to pursue investments in areas that have the potential for long-term outsized returns compared to traditional equities, though they may be more volatile along the way. Some areas of the Emerging Markets as well initiatives such as Clean Energy and Global Infrastructure are examples of such open-minded thinking that is not presently accounted for in most Target Date offerings.

Glide path

The other misleading feature is the so-called “glide path.” As a fund gets closer and closer to its target date, it automatically becomes more conservative, with more of the assets going to bonds and away from stocks. This automatic shift in assets could end up being the worst-case move for investors.

What if you bought a Target Date Fund that targets a 2015 retirement date, and you bought it back in 2000. As of early 2010, your total return net of taxes was probably somewhere around zero, give or take a few percent. Why? Because your fund allocated heavily to stocks when you bought it in 2000 – right as the market peaked.

Now that you are within a handful of years to retirement in 2015, your glide path will dictate that you accelerate the shift out of stocks, and bulk up on bonds instead – at at point where bond rates were at historic lows, so upside was limited for you there. Talk about an “Off-Target” investment plan!

The criteria I would advise an investor to use when evaluating asset allocation strategies are not met by any Target Date Funds on the market, at least not as of this writing. The key thing investors should insist on when pursuing a plan to put their retirement investment savings plan on “auto-pilot” is the ability to adapt to changes in the broad financial market environment.

Ludicrous

I am not talking about trading, but about longer-term cyclical and secular changes in the stock and bond market. The stock and bond markets ebb and flow over time, and to simply determine today what asset allocation changes you will make many years from now (which is what a glide path does) seems ludicrous to me.

In retirement investing, like life itself, hurdles and surprises come at you, and you have to adapt. Target Date Funds do not prepare investors for that unfortunate reality.

Allocation Funds: a better solution for pre-retirees

While I dislike Target Date Funds, my opinion remains that for many investors, a “set it and forget it” portion of their portfolio is a good way to prevent them from self-inflicted investment wounds. Fortunately, there are less complicated solutions.

There are several capable mutual fund managers that allocate among different traditional and non-traditional asset classes. Some are managed by a single firm using multiple styles, and others take a “multi-manager” approach, in which the fund manager allocates among several money management firms, each with its own specific style.

The fund manager’s job is to find and maintain a mix of managers and styles that allows the fund to pursue its stated objectives. Again, hedging is not common here, but it’s a lot more common than in the Target Date Fund universe.

For the strategies and mutual fund I manage, this is a central part of my responsibility: putting together the asset allocation puzzle and adjusting when needed.

Problem negated

By using more flexibly-managed allocation funds, an investor gets a wider reach from their retirement portfolio. The glide path problem is largely negated, as the allocation fund manager is charged with balancing risk and return at all times.

Allocation funds don’t specifically target a retirement date, but compared to Target Date Funds, I firmly believe they give you a far better chance to get there, and the possibility of a much smoother ride along the way.



Note that most target date funds and many allocation funds are run by money management firms with massive assets, massive distribution muscle and massive advertising budgets.

But I believe it would be a mistake for an investor to simply choose a retirement-oriented fund based on the assumed comfort that goes with size. On Wall Street, we have seen over and over again in the past few years that the bigger they are, the harder they fall.

Robert A. Isbitts, a 23-year industry veteran, is a newsletter writer, published author, and the Chief Investment Officer of Emerald Asset Advisors LLC, a South Florida RIA firm. He created and manages a series of separate accounts available to RIAs, and is the lead-manager of an asset allocation mutual fund. For more information on that mutual fund, visit www.easfunds.com. Rob can be reached directly at risbitts@emeraldasset.com.

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