Target-date turnaround lowers the heat on managers' returns

A rebound last year after a bludgeoning in 2008 has money managers breathing a bit easier about their near-term target-date funds.

Some of 2008's laggards among near-term funds, commonly known as 2010 target-date funds, turned in the best results last year.

For example, AllianceBernstein's 2010 Retirement Strategy Class I fund for institutional investors returned 29.6%, and T. Rowe Price Group's Retirement 2010 fund, 28%. Both are well above the average 2010 fund gain of 22.4%, according to Morningstar Inc., Chicago.

The research firm's calculation for performance represents a simple average of all classes of 2010 funds, including institutional and retail.

Because of their poor performance in 2008, these defined contribution plan investment vehicles have been sharply criticized by legislators and others for their high equity allocations.

In fact, Sen. Herbert Kohl, D-Wis., chairman of the Senate Special Committee on Aging, is expected to introduce legislation this spring that would expand the fiduciary responsibility for target-date funds to service providers, and not just plan sponsors.

“Millions of Americans are defaulted into target-date funds, and will rely on this investment as their primary source of retirement income down the road,” Mr. Kohl said in an e-mail to Pensions & Investments. “Our bill will make sure these investors are getting the strong fiduciary protections they deserve.”

In theory, target-date funds were designed to have less equity exposure and more fixed-income exposure the closer they got to the target retirement date. In practice, however, 2010 target-date funds had an average equity exposure of 46.5% in 2008, a year in which the stock market tanked and 2010 funds lost an average 25.1%, according to Morningstar.

“Most companies whose funds have aggressive equity allocations realized they had to sit tight (in 2009) to recover,” said Joshua Charlson, a senior fund analyst at Morningstar.

Although equity-heavy 2010 funds were hit hard in 2008, they didn't automatically get a big bounce-back last year. If their fixed-income components performed poorly, their total returns were suppressed, he said.

The 2010 funds that did best in softening the blows of 2008 and capitalizing on the rebound in 2009 were those with, among other skills, strong stock-picking and a “higher-quality” fixed-income focus in 2008, Mr. Charlson said.

The rebound in 2009 also gave money managers a chance to say “I told you so” in the name of long-term investing. “You don't measure with a ruler what you need to measure with a yardstick,” Kristi Mitchem, head of the U.S. defined contribution business for New York-based BlackRock Inc., said in an interview. The industry was wise to ignore pressure to change target-date fund formulas based on a bad year or bad quarter, she said.

(Returns in 2008 for BlackRock's three 2010 funds ranged from -24.9% to -25.5%; last year's returns ranged from 23.7% to 24.7%.)

Jonathan Shelon, portfolio manager of Boston-based Fidelity Investments' Freedom Funds, likened 2008 to a storm that happens once every 80 to 100 years.

“People should focus on the full return over time, rather than one year,” said Mr. Shelon. He said the portfolio design for 2010 funds and other target-date funds “still makes sense” given participants' longer life spans.

Fidelity's biggest 2010 target-date fund is the $11.3 billion Fidelity Freedom 2010, which lost 25.3% in 2008 but gained 24.8% last year, according to Morningstar. Its equity component was 49.8% in 2008 and 50.9% last year.

Another huge player is The Vanguard Group Inc. Its $3.4 billion Target 2010 Retirement fund returned -20.7% in 2008 and 19.3% last year, Morningstar said.

Many money managers defend their high-equity allocations for funds nearing their target dates, saying their formulas reflect a need to provide enough money for people to enjoy 20-plus years past the traditional retirement age of 65.

“If you substantially de-risked at age 65, especially in this environment, there's virtually no chance” that your target-date investment will provide adequate income, Seth Masters, chief investment officer of AllianceBernstein Defined Contribution Investments, said in an interview. “A de-risked portfolio is a smooth path to failure.”

New York-based AllianceBernstein LP had one of the worst 2008 performances of the 2010 target-date funds monitored by Morningstar. Its Class I shares were down 32.7%. It also had one of the best comebacks in 2009, up 29.6%. The company has six other 2010 funds.

AllianceBernstein also has a high equity allocation — 63.6% last year and 65.1% in 2008.

Mr. Masters makes no apology. Although his 2010 funds were battered in 2008, “we stuck to our guns,” he said. “We didn't change our approach. You can't make cosmic conclusions based over a two-year period.”

The average equity allocation for the universe of 2010 funds was 44.7% in 2009 and 46.5% in 2008, according to Morningstar, which counts both stocks and real estate investment trusts as equities.

T. Rowe Price Group, Baltimore, which has a higher-than-average equity allocation for its three 2010 funds, promotes a similar stay-calm philosophy.

“We know our approach can be uncomfortable in a bear market,” said Jerome Clark, a T. Rowe Price portfolio manager. “The most important thing an investor can do in a bear market is stay the course.”

Mr. Clark said his 2010 funds' showing in 2008 “was not a surprise given what was going on in the market.” However, being uncomfortable in 2008 is better than “being devastated in 25 to 30 years” if participants outlive their assets, said Mr. Clark, adding that T. Rowe's glidepaths extend 30 years beyond a target date.

“The time horizon is not retirement; it's life expectancy,” he said.

The T. Rowe Price target-date formula calls for a 55% equity allocation at age 65, then 35% at age 80 and 20% at age 95 and beyond.

During 2008, the largest T. Rowe Price Retirement 2010 fund, with $3.9 billion in assets, had an equity allocation of 58.3%; it lost 26.7%. Last year, the equity allocation was 58.5%, and the fund gained 28%.

The rebound “provided validation that the short term can change so quickly,” Mr. Clark said. “That's why we tell our investors and clients to take a more holistic look at investing for the long term.”

One fund hit hard in 2008 was the Goldman Sachs Retirement Strategy 2010 institutional shares fund, which lost 30.4%. Last year, the fund gained 25.9%. Goldman has three other 2010 funds.

“Certainly 2008 was a very, very difficult period,” Theodore P. Enders, vice president and portfolio strategist for New York-based Goldman Sachs Asset Management, said in an interview. “In 2009, we saw a sharp recovery.”

He added that 2008 must be placed in context. “Events like 2008 have happened before” during the history of stock market oscillations going back to the 1930s and earlier.

Because participants will “most likely live decades beyond the target date,” Goldman Sachs prefers a strong equity component even as the funds approach their target dates. The equity allocation last year, according to Morningstar, was 63.1%. The company designs funds with a glidepath of three to five years past the target date. Then, a fund's equity allocation will remain at 40%.

“The biggest lesson of the last two years: Do not try to time the market,” said Jeffrey R. Carney, global head of marketing for Boston-based Putnam Investments. “Have a plan; be diversified. There's no perfect system.”

(Putnam Retirement Ready 2010 Fund Class Y institutional shares dropped 26% in 2008 but snapped back with a 25.6% gain last year, according to Morningstar. Five other Putnam Retirement Ready 2010 funds had similar losses in 2008 and similar gains in 2009.)

Despite a brutal 2008, target-date funds are becoming more popular.

A recently released survey by Callan Associates of 90 plan sponsors, conducted in late 2009, found that 69% had target-date funds as a qualified default investment alternative, compared with 59% in 2008.

“Despite the criticism of target-date funds, the vast majority (of sponsors surveyed) are saying this is the best choice,” Lori Lucas, executive vice president and defined contribution practice leader, said in an interview.

Still, she added, there are lessons to be learned from the last two years. “Target-date funds are not commodities,” she said. “They require rigorous monitoring, analysis and evaluation by sponsors.”