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Thursday, April 30, 2009

Target Date Funds...This Doesn't Solve Their Problem

I have written several times about target date funds which claim to adjust the allocation between asset classes based on the target (retirement) date of the fund. The problem with these funds is the lack of clarity of the "glide path" in which the funds reduce the allocation to stocks and increase the allocation to bonds to reduce volatility as the target date approaches (see the example in the graphic at left). Since the investor is often not aware of the glide path, and the manager may change it the investor is often left in the dark. Target funds with the same date but different managers will often have different "glide paths". Additionally since the target date does fund does not "know" what other assets are held by the investor, the glide path may not be appropriate to the investor even if he plans to retire at the target date. For example if the investor holds his target date fund in his 401k and has considerable assets in taxable accounts it might be advantageous to draw first on the taxable account to fund retirement needs so as to accumulate more in the tax deferred account.

The WSJ today writes about new changes to the targe date funds but it seems to me they don't deal with the main problem which is outlined above. As the WSJ writes (my bolds):

...Some retirement plan sponsors have offered customized target-date fund lineups for three or four years, and it isn't unusual for plans with $1 billion or more in assets to do so, Mr. Suess said. Typically they are created with the help of a consultant, using funds already chosen for a company's defined-contribution or defined-benefit plan.

Among Hewitt Associates' clients, almost 20% of those with target-date funds mix their own, said Pam Hess, director of retirement research at the consulting firm. More broadly, it is probably closer to 5% of plans but growing significantly, she said.

Customized lineups are attractive for a variety of reasons.

They allow a company to avoid the risk that comes with placing all their assets with one entity. Also, the company may have already taken the time to select the best manager in each investment category, and now can negotiate lower fees by placing more assets with those managers.

"The plan sponsor has done a lot of work developing this core line-up," said David Wray, president of the Profit Sharing/401(k) Council of America. "Why wouldn't they want that to expand to their target-date program as well?"

It's simpler to change funds if one or more in a line-up are poor performers. A plan sponsor could remove an underperforming large-cap equity fund, for example, without having to change everything else, Mr. Suess noted. That can't be done with a bundled product.
There are now more consultants willing to take on the fiduciary duty of setting up so-called glide paths, which are the schedules for how a fund's assets will be reallocated over time, and of choosing investment managers.

James Worrell, president of GPS Investment Advisors LLC, a retirement plan consultant, said he has worked with two 401(k) plans that used their core funds to create age-based and risk-based portfolios.

Flexibility, performance and investment philosophy, in terms of construction of the funds' glide paths, are all factors driving the trend, he said.

Two Observations:

1. While it may be true that there is some advantage to incorporating funds from various fund families into the target date funds, it adds the additional pitfall of choosing active managers. Since we know past performance tells little about future performance among fund managers, how can one be sure the consultant picks the "best large cap manager" and what will be the criteria and frequency of decisions to drop "underperforming manager.

Of course this problem could be solved by making the allocation within the target date funds a mix of index funds or etfs covering major asset classes.

2. Using a consultant rather than the fund company to set the "glide path" doesn't solve any of the problems I outlined above, it merely changes who makes the decisions.

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