TowerGroup, Needham, Mass., estimates that allocations to target-date funds will grow to 56% of assets in all defined contribution plans by 2011, up from 11% this year. Assets in these funds, which decrease in equity holdings as a participant ages, now hold about $370 billion of retirement plan assets, up from $150 billion at the end of 2004, according to Financial Research Corp., Boston.
But some consultants argue the high equity exposures of target-date funds leave participants open to too much risk. Ultimately, they say, plan sponsors could be left holding the bag if participants’ accounts are decimated by poor performance.
Executives say problems with target-date funds are far-reaching:
cEquity allocations are too high, exposing participants to too much risk in bear markets;
cSuccess depends on performance running up to retirement; and
cLimited asset classes.
How managers structure target-date funds is becoming more important as plans increasingly use them as the default option.
Stable value hit
The DOL regulation, which implements the law and goes into effect Dec. 24, gives a nod to stable-value funds, considered the big loser under the change. The rule says plan sponsors could receive legal protection by placing employee investments in a stable value fund for the first 120 days of their participation in a defined contribution plan. Bradford P. Campbell, assistant secretary of Labor and head of the Employee Benefits Security Administration, said in a conference call with reporters that the temporary default was offered as an administrative convenience for plan sponsors.
In addition, the DOL’s new rules provide protection for investments made in stable value funds before the Dec. 24 effective date of the new QDIA regulations. The grandfathered protection is intended to minimize costs associated with transferring the funds.
Still, proponents of stable value funds have not thrown in the towel.
“There’s going to be a lot of messaging from us about the value of stable value,” said Jack Dolan, a spokesman for the American Council of Life Insurers, Washington. “Plan sponsors have to know that stable value funds represent an entirely appropriate investment vehicle for plan participants.”
Gina Mitchell, president of the Stable Value Investment Association, Washington, said officials at her organization interpret the DOL’s new rules to mean that plan sponsors are free to continue using stable value funds as a default — if they determine that stable value is the most prudent choice of a default for their plan participants.
Target-date funds buoyed
Still, target-date funds are expected to clean up. The question is whether they will provide adequate retirement income for plan participants.
Elliot Fineman, senior vice president of Compass Institute, an investment research and asset management company in Kenilworth, Ill., said target-date funds as currently structured will not generate enough income for participants at retirement. There is simply too much risk of investments going sour, he said.
“Our empirical research shows that traditional asset-allocation investing leaves retirees with long-term average annual returns of 6.4% over market cycles. That is nowhere near the long-term 12% AAR over market cycles that retirees need to earn in their 401(k)s in order to have sufficient funds at retirement,” Mr. Fineman said.
Richard Glass, president of investment advisory firm Investment Horizons Inc., Pittsburgh, said that while target-date funds are a good concept, their success will depend on framing them properly.
“All the studies have shown that the average participant knows very little about investing. They don’t understand the basics of investing. If you left people up to their own devices, they have a problem right then and there. But there are a few concerns,” said Mr. Glass.
The desire to take on more equity risk is being driven by competition among managers and not necessarily what’s best for participants, he said. Sponsors could be held liable if they make the wrong choice, he added.
“Three years ago, if you looked at an average target-date fund, 50% of assets were in stocks until you (were) 60; now it’s much higher. The problem is comparing the different target-date funds. If I have 50% in stocks, and the next guy has 30% and the market is up, the 30% guy will look bad. At what point is the goal to conserve assets rather than go for growth? So much of what you’re talking about now, so much risk is being taken to make up for the lack of contributions,” said Mr. Glass.
According to data by Hewitt Associates LLC, Lincolnshire, Ill., more aggressive target-date funds have equity allocations up to 94%, compared with 80% three years ago.
Other shortcomings
Other asset management executives said target-date funds are not using enough asset classes, to the detriment of participants. Firms should offer target-date funds that include non-traditional classes such as commodities and Treasury inflation-protected securities.
Stacy Schaus, defined contribution practice leader for Pacific Investment Management Co., Newport Beach, Calif., said the risk of not being able to meet the goal of providing adequate retirement income is unacceptable.
“At PIMCO, we look at the probability of participants meeting their retirement income goals and we look to real assets for inflation protection,” she said.
Recent market experience will heavily affect participant’s retirement kitties.
DC plans need to strike a balance between real appreciation potential and downside protection to offer the best level of equities, which decreases as participants age, said Ms. Schaus. Incorporating liability-driven investing into target-date funds can minimize the risk taken by 401(k) plan participants, she added.
Drew Carrington, executive director and head of defined contribution and retirement solutions at UBS Global Asset Management, Chicago, said target-date funds have a role in 401(k) plans and will continue to do so, but many first-generation target-date funds are leaving participants open to too much risk.
UBS recently launched target-date funds that incorporate TIPS, he said. Plan executives are concerned with participants taking on too much inflation risk and are responding positively to the use of TIPS, he said.
