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Target Funds Miss the Mark

Some target-date managers are rethinking their investment strategies.

In a year when the performance of almost every asset class worldwide was a disaster, one defined contribution investment in particular stands out for its shock value: target-date funds, the increasingly popular funds of funds that automatically adjust asset allocation as participants move closer to their expected retirement age.

As many participants saw it, they were getting a professionally managed, diversified portfolio that would keep them within a carefully calibrated range of risk. But despite that expectation, their holdings plunged by just over 24 percent, on average, in 2008, with some target-date funds posting much steeper drops.

It turns out that there are huge discrepancies between the way these funds are perceived and the way that many of them are actually constructed. “Participants had the impression that they had a secure retirement, not realizing that they had a risky retirement,” says Mark Ruloff, director of asset allocation at the Washington-based consulting firm Watson Wyatt Worldwide. Matthew Gannon, director of defined contribution investments at MFS Investment Management in Boston, which runs $172.2 million in target-date assets, notes that “the simplicity of the target-date approach impacted people’s perceptions of what they were actually getting.”

As a result, some target-date managers are rethinking their investment strategies, looking at everything from derivatives to oil and gas partnerships in search of more downside protection. Vendors are cooking up new forms of guarantees.

All this second-guessing, moreover, comes at a time of broader skepticism over defined contribution plans. Many politicians are questioning whether 401(k) plans can ever provide enough retirement income. The House Education and Labor Committee held a hearing on the topic in October, and during the presidential campaign, President Barack Obama proposed mandatory payroll-deduction IRAs at companies without retirement plans.

When target-date funds and their cousins, lifestyle funds, were created in the 1990s, they were seen as the solution to a gaping flaw in 401(k) plans — that too many employees don’t know or care how to make wise investment choices. With these new products, computer programs take over the decision making. Lifestyle funds offer a choice of portfolios based on risk tolerance — conservative, moderate or aggressive.

For target-date funds the asset allocation is roughly correlated with the year the participant expects to retire, with the mix typically starting at 85 or 90 percent equities and gradually shifting to lower-risk investments as the magic age gets closer, in what’s called a glide path. The assumption is that younger people need to build up returns, while older people should preserve capital. (Since companies have target-date funds only for years ending in “5” and “0,” anyone turning 65 in, say, 2033 has to choose the fund that corresponds most closely to that year, which in such case would be 2035.)

Target-date funds have been gradually crowding out the lifestyle versions, largely because it’s easier for participants to estimate when they want to retire than to analyze how much risk they are willing to take. The concept got a boost from the Pension Protection Act of 2006, which allowed these funds to be the default investment option when employers automatically enroll employees into 401(k) plans. Cerulli Associates, of Boston, estimates that total target-date assets topped $185 billion last year.

On the whole, these funds didn’t underperform the market in 2008. The big controversy centers around the 2010 offerings, which on average fell by 24.6 percent, according to Morningstar’s data. Many investors in those funds were presumably expecting to retire on their assets next year or even earlier. Suddenly, they’ve only got three fourths of what they were counting on.

The heart of the problem, experts say, is that some participants appear to have mistakenly concluded that a fund with a looming end date would be heavily weighted toward bonds, money market funds or other, less-risky investments. “Some people may have assumed that these funds cease to exist on that date and endow,” says Jonathan Shelon, a fund-of-funds portfolio manager at Boston-based Fidelity Investments, which manages $69 billion in target-date funds. “Participants expected the feeling of more security, as your retirement target fund gets closer to that retirement date, and that fixed income would be a buffer,” notes Gino Reina, director of research at Segal Advisors, the investment consulting arm of the New York City–based consulting firm Segal Co.

In fact, the allocation in many target-date funds is still about evenly split between equities and fixed income at the target retirement age. Equity allocation often doesn’t hit bottom — 20 to 30 percent of assets — for another seven years or more. At Baltimore-based T. Rowe Price, a 90-year-old who had retired at age 65 would still have 26 percent in stocks. Fidelity doesn’t reduce equities to their minimum level until participants reach age 80. Both firms’ 2010 funds did worse than the Morningstar average, dropping by 26.7 percent and 25.3 percent, respectively.

Target-date fund managers say their asset allocation approach makes sense, the controversy over last year’s results notwithstanding. “2008 is one year out of many,” says Jerome Clark, the manager of T. Rowe Price’s retirement funds, in defending his firm’s asset mix. “When you look over long time periods, we’ve designed a glide path that we believe is going to be successful in 90 percent of the markets.” (The firm manages nearly $30 billion in target-date funds.) With people living well beyond age 65, Clark and other managers say, it doesn’t make sense to shift to a maintenance allocation the day they stop working. “It is intended to be a lifetime strategy,” Fidelity’s Shelon says. He admits that “there has certainly been heightened recognition that the naming convention — using a target date of convenience — needs some clarification.” However, he doesn’t advocate changing the nomenclature, and he says most participants understand the asset allocation.

But did managers fully explain this stock-heavy weighting to 401(k) investors? “There’s been no miscommunication. There’s been no hiding what these things are made up of,” Clark insists. The pie charts are right there in the enrollment materials, after all. John Ameriks, head of investment counseling and research at Malvern, Pennsylvania–based Vanguard Group, which manages more than $32 billion in target-date assets, says that an internal analysis a few years ago showed that target-date customers actually wanted more equities, which is why Vanguard increased the equity component from 10 percent to 20 percent across its 11 funds in 2006. “People, having come out of the dot-com bust, are familiar with the ups and downs in the markets,” Ameriks asserts.

Independent experts are skeptical of the industry’s allocation approach. “Target-date funds, by virtue of having that date in their name and by the way they are presented, have a duty to their investors that would seem to include minimizing losses at or near the target date. Fund providers failed their investors,” argues Joseph Nagengast, a principal at Target Date Analytics, a consulting firm based in Marina del Rey, California, that analyzes these funds and creates indexes. “Whether there wasn’t a complete enough communication, that’s an area people are reconsidering,” says David Wray, president of the Profit Sharing/401(k) Council of America, a trade group based in Chicago.

With investors and clients so nervous, some target-date managers are looking at ways to refine their investment lineup. One obvious step would be to put in an income guarantee, but that’s easier said than done. Des Moines, Iowa–based Principal Financial Group spent a lot of time last year trying to design “a well-diversified investment portfolio associated with your risk tolerance, plus a rider with the ability to buy an insurance policy that would guarantee some minimum level of income on that portfolio as long as you live,” says David Reichart, a senior vice president of Principal’s mutual fund arm, which has $9.3 billion of target-date funds. But, he explains, the “pricing became usurious.” Reichart had hoped to keep the fee to a total of 2 percent, but he was getting quotes of 2 percent just for the rider.

If he can’t guarantee a safe return, Reichart is at least aiming to lower his target-date funds’ risk profile by increasing diversification with two new asset classes, which he expects to add this year. One class would invest in what Principal calls real return capability as a hedge against the inflation that the firm expects from the federal stimulus package. Investments could include commodities, inflation-indexed Treasuries, real estate investment trusts, natural resources stocks, oil and gas limited partnerships, and infrastructure-related securities. Infrastructure projects, for instance, “tend to earn on a revenue basis. As inflation rises, these types of investments are often able to raise their fees,” explains Michael Finnegan, Principal’s chief investment officer. The second new asset class would be an absolute-return fund using market-neutral strategies to hedge against the rest of the portfolio. Together the two new categories might constitute 10 to 30 percent of a portfolio, depending on the target date, replacing part of the equities, real estate and fixed-income sectors.

MFS has taken a more conservative glide path all along, downshifting to 20 percent equities promptly at retirement age. “We did a lot of historical analysis, looking at what happens in those first few years of retirement if you get a down event,” explains Joseph Flaherty, a portfolio manager at MFS. Not surprisingly, its 2010 fund beat the averages, dropping less than 14.3 percent. Even so, MFS decided “to bring in some noncorrelated asset classes that will help mitigate some of the risk on the downside and still bring some upside potential,” says MFS’s Gannon. For some vendors this is the perfect opportunity to jump in with risk-reduction products that have been sitting on the shelf, waiting for takers. For instance, how about a diversified portfolio of ten exchange-traded funds, with an option on each bought at the target retirement date? That’s the brainchild of Financial InterGroup Advisors, a small New York City–based financial advisory firm. As president Allan Grody explains, this structure solves an inherent problem with target-date funds: Normally, the fund has to sell off a chunk of its stock holdings at the designated date, even if the market has plunged — as in 2008. Although no customers have signed up for this ETF product after two years of marketing, Grody says chances should be better now that he is pitching directly to plan sponsors rather than to mutual fund and insurance companies.

One new risk product from Metropolitan Life Insurance Co., of New York, and Barclays Global Investors, of San Francisco, is on the way. In August 2007 they paired up to combine an annuity with a target-date fund. Part of the employee contribution each year would go to buy annuities, which would constitute the portfolio’s fixed-income allocation, and the interest rates of all those annuities would be aggregated at retirement to create a guaranteed income stream. But what of the standard complaint about annuities, that they’re only as strong as the insurance company issuing them? Jody Strakosch, MetLife’s national director of institutional strategic alliances, says the new product avoids that problem, because “Barclays does have the right to use multiple carriers.” This innovation, too, has not yet found takers. Another way of hedging risk is liability matching, or buying bonds that mature exactly when people plan to retire. It’s a concept that has been growing slowly in defined benefit plans. However, even Zvi Bodie, a management professor at Boston University and one of their strongest advocates, admits that defined contribution sponsors will be reluctant to use this strategy as long as Labor Department rules require an equity component in the default investment.

Not every manager is rushing to alter its investment mix. Ameriks of Vanguard points out that target-date funds were hardly alone in suffering last year. Observes Clark of T. Rowe Price: “The important thing is for the participant to stay in the market. Over the longer time period, not participating in the equity markets is really setting yourself up for failure.”

But others say that 2008 has altered investor psychology, and money managers must be sensitive to that. “I don’t think that people before thought it was important to have a guaranteed income payment,” says MetLife’s Strakosch.