The goal of target date or target risk strategies is to make pension plans or private savings for retirement simpler, more attractive and successful for pension participants and/or general investors saving for retirement. Unfortunately, they often fall far short of that lofty goal.
Most pension and 401(k) investors are unwilling and/or unable to construct optimum asset allocation plans. The days when a plan sponsor could throw 50 or so mutual funds at participants and expect them to reach appropriate asset allocation plans by themselves are long gone; pension participants want and need help to solve those problems. (Learn why buying after the Fed cuts interest rates isn't always the best idea, in Rate Cuts Don't Guarantee Great Returns.)
Using a glide slope which systematically reduces risk in the portfolio over time by varying the ratio of stocks to fixed income as a starting point, two general approaches attempt to solve the problem for the investor:
- Target risk or so-called lifestyle plans hold risk steady, without regard to the age of the participant. The participant changes the risk of his/her portfolio by selling one strategy and purchasing another.
- Target date funds constantly adjust the mix to reduce risk as the participant progresses toward a date certain.
Adjusting Your Position
Target risk or lifestyle arrangements allow the participant control of the timing of adjustments and amount of risk that he or she desires to bear. It's up to the participant to select the appropriate amount of risk, and make adjustments as his or her situation changes.
On the other hand, target date arrangements are a "select and forget" solution. Once a target date is selected, everything is handled automatically. Equities or stock positions are systematically reduced to the target level at some point at or prior to retirement.
In theory, both target risk and target date approaches claim to take care of all the messy details investors find so daunting. Asset allocation of both the equity and bond positions is selected for the participant along with fund selection, re-balancing and performance monitoring. What could be nicer? (Read on to determine, How Risk Free Is The Risk-Free Rate Of Return?.)
Problems in TargetLand
The apparent simplicity of the approaches has made them extremely popular with investors and plan sponsors. The idea that the plan participant can solve an entire pension decision and ongoing management responsibilities with a single check mark is irresistible.
The equity meltdown of 2008 exposed the inherent problems with both approaches. The press is full of stories about anguished investors losing 20-40% of their account value in the year before retirement. This pain is very real, and the ensuing attention prompted outcries from "betrayed" investors, generated Congressional hearings and galvanized regulators in the Securities and Exchange Commission (SEC) and Labor Department into a frenzy of regulation writing.
Putting the best possible spin on it, the industry has done a miserable job of explaining its target arrangements, whether target risk or date. Investors simply do not understand the amount of risk that they are assuming. For instance, some investors believed that their target date arrangements reduced their risk to zero just before retirement. But, most arrangements target an equity exposure of 40-60% at retirement. In theory, this level of risk is entirely appropriate for a retirement portfolio designed to last a lifetime and bearing only sustainable withdrawals. That's what this author would recommend to private clients rolling over their retirement plan nest egg into a portfolio with a lifetime income objective. However, the disconnect between plan design objectives and participant expectations is enormous. (Learn how catch-up contributions can help you increase your nest egg, in Retirement Savings Tips For 45- To 54-Year-Olds.)
The Miseducation of Plan Participants
In fact, plan participants are grossly misinformed on the uses and limitations of target arrangements. A recent survey by Chicago-based Envestnet Asset Management, Inc. disclosed the following disturbing misperceptions:
- Nearly 62% of the respondents felt that they would be able to retire on the fund's target date.
- Almost 38% of the polled participants believed the funds had a guaranteed return.
- More than 33% thought their money would grow faster in target date funds than other investments.
- About 30% felt that the funds allowed them to save less in order to reach their retirement goals.
Divide and ...
Further, rather than follow a suggested strategy within a target fund, a significant number of participants will select multiple strategies, or worse yet, simply divide their accounts by the total number of plan options, including lifestyle and target date funds offered by the plan believing that they achieve better diversification. In the process, they lose effective control of asset allocation and likely increase their costs.
The lack of any standard definition of the glide slope presents additional opportunities for confusion. One target date arrangement may terminate the glide slope at retirement with 80% equities while another might be at 40%. Two plan participants with identical objectives could have vastly different amounts at risk. Valid arguments might be advanced for either position, but how is the guy on the shop floor to sort them out? If he can't sort them out, how is he ever going to appreciate how they might perform in different market conditions and which best meets his goals?
A lively debate is already underway about how the glide slope should be constructed, and whether they should be standardized by regulation. At one extreme, because most participants will roll over their accounts at retirement, one faction is supporting a 0% allocation at or prior to retirement date. We may not need to standardize the glide slope by regulation, but we must certainly educate participants about the implications of the strategies they are offered.
Marketing names attached to lifestyle or target risk arrangements are another source of confusion to investors. One company's aggressive mix may be 100% equities while a competitor's aggressive mix might be 70% equities. Terms like "aggressive" have little or no meaning. For instance, in the world beyond pension plans, an aggressive portfolio might be leveraged up to the equivalent of 400% equities or more. Balanced approaches can run the gamut from 40% to 60% equities. A far more transparent and sensible approach might be to re-name the approaches to their equity/fixed income percentages. For example an "80% equity/20% fixed income" portfolio far better defines the mix of the investment arrangement and allows some idea of the associated risk.
Differences in Construction: Target Fund Vs. Target Portfolio
Pension providers supply variations of the two strategies in two distinct flavors. The differences are not trivial.
- A target date or lifestyle fund is a product sold by a product distributor, such as an insurance company or mutual fund company. Typically a "fund of funds," a single fund, buys interests in a number of other funds as an entire portfolio.
There are a number of potential problems with this solution which have consumers, plan sponsors and regulators scratching their heads. Proposed regulations are inevitable.
The asset allocation decisions and capital market assumptions are a black box. No data is generally provided for expenses, assumed returns of the underlying funds, criteria for their selection, risk of the individual funds or of the entire portfolio.
Asset allocation mixes vary widely. While one master fund may contain a dozen distinct asset classes with true global diversification, another may simply contain domestic large company stocks with a token allocation to foreign and small companies. The risk and return characteristics of the different asset allocation selections will have a major impact on their ultimate success.
Proprietary fund selection is always a concern. Little information is disclosed on conflicts of interest, revenue sharing, pay to play concessions or other fiduciary breaches.
Mutual fund products are not presently subject to ERISA, and so fiduciary requirements including disclosure of conflicts mentioned in "c" above are not required. Regulators are hard at work closing this loophole.
- Target portfolios, on the other hand, are individually constructed by the plan's advisor from a menu of plan offerings to achieve specific risk-reward parameters, with full disclosure of the underlying assumptions and full transparency of selection criteria. Individual funds within the portfolio that underperform or otherwise merit replacement can be easily substituted in a fully transparent process.
Providing tailor-made asset allocation plans suitable for the vast majority of plan participants at various stages of their career is a lofty and worthy goal. But much remains to be done before it is achieved. Specifically, based on the observed data, it's highly unlikely that participants, plan sponsors or regulators understand what's under the hood of most arrangements. Employee education, disclosure, costs, risk analysis, asset allocation and fiduciary standards can and must all be radically improved.