Invesco Ltd. and Pacific Investment Management Co. are adding riskier assets and complicated strategies in target-date funds as they seek to gain ground on Fidelity Investments and Vanguard Group Inc. in this fast growing segment of the U.S. retirement market.
While sellers promote target-date funds as a simple choice for people who don't want to pick their own investments and rebalance them, money managers are using inflation hedges and derivatives to bolster returns. That broadening doesn't address target-date funds' main issues: uneven returns, higher expenses and an inability to provide for individual retirement needs, said Bob Pozen, a senior lecturer of business administration at Harvard Business School and former chairman of MFS Investment Management.
Target-date mutual funds hold a mix of assets that become more conservative as employees age, which is why employers favor them when automatically enrolling workers in defined contribution plans. Investments in the funds have swelled more than 380% since 2005 to about $343 billion as of September, according to the Investment Company Institute, a Washington-based trade group for the mutual fund industry.
“Some people are losing sight of the risk-management goal by adding all these additional asset classes,” said Jim Lauder, CEO of Global Index Advisors, whose Atlanta-based firm runs about $14 billion in subadvised target-date fund assets. “If you devastate their portfolios, inflation doesn't matter.”
Target-date funds' growth has attracted attention as studies, including those by the Government Accountability Office, have shown that Americans might outlive their savings. Less than 15% of Americans are very confident they'll have enough money to live comfortably in retirement, the Washington-based Employee Benefit Research Institute said in a study released March 13.
Invesco and PIMCO are trying to attract assets by using more exotic strategies, which generally have higher fees, said Laura Lutton, an editorial director in the fund research group at Chicago-based Morningstar Inc.
Invesco uses exchange-traded futures and some swaps on futures to invest in commodities, said Scott Wolle, chief investment officer of Invesco Global Asset Allocation. It also uses the derivatives to trade in six global equity markets and sovereign bond markets, including Australia, Japan and Germany. Atlanta-based Invesco started offering target-date funds in 2007 and has about $256 million in assets, Mr. Wolle said.
“There's complexity in the guts of how we manage the portfolio but there's a simple approach,” he said. “We're trying to win by not losing.”
Invesco's target-date fund for those retiring in 2020 returned about 9.8% last year with dividends reinvested, according to data compiled by Bloomberg. The average target-date fund lost about 1.6% last year, Morningstar data show, while the Standard & Poor's 500 index gained about 2.1% with dividends reinvested.
PIMCO's offerings saw a 398% jump in assets last year to reach $180 million, said John Miller, head of U.S. defined contribution and retirement for the firm. The Newport Beach, Calif.-based company uses derivatives in its target-date funds to hedge against inflation, credit risks and currency dislocations by purchasing options contracts, futures or swaps, Mr. Miller said.
Derivatives are financial instruments used to hedge risks or for speculation. They're derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.
“While the hedges do cost something in terms of putting them into the portfolio, they have the potential to not only pay for themselves but they can and have been a source of outperformance at least historically,” said Mr. Miller, who's also a managing director at the firm.
PIMCO's target-date fund for those retiring around 2020 returned about 2% with dividends reinvested last year. The firm started selling its target-date funds about four years ago because of their increased use by 401(k) plans, Mr. Miller said.
The majority, or 53%, of plan sponsors that automatically enroll participants in 401(k)s use target-date funds as the default investment, according to a 2011 report by the Plan Sponsor Council of America, a Chicago-based trade group. There are more than 40 target-date mutual fund families employers may choose from and some sellers also offer them in collective trusts or customized versions, said Jeremy Stempien, director of investments for the retirement solutions group at Morningstar Investment Management.
“We can see tremendous discrepancy, tremendous differences among asset managers,” said Harvard's Mr. Pozen, who's also a senior fellow at the Brookings Institution. “I don't think most people understand what they're getting.”
Fidelity, Vanguard and T. Rowe Price Group Inc. controlled about 75% of the target-date assets in 2011, according to Morningstar. The average fee for a target-date mutual fund last year was about 1.1%, according to Morningstar, which included all share classes and retirement years such as the 2030 or 2040 funds.
Fees for the funds at PIMCO and Invesco averaged about 1.2%. Vanguard, which mainly uses three broad-market index funds in its series, had the lowest expenses, around 19 basis points, or 84% less than the more expensive funds.
In 2008, some target-date funds designed for those near retirement lost as much as 41% while the S&P 500 Index fell about 38%, according to Morningstar. Since then many providers have diversified their holdings and added asset classes to protect against inflation and falling markets.
Providers including JP Morgan Chase & Co., AllianceBernstein Holding LP, Northern Trust Corp. and State Street Global Advisors have increased allocations to inflation-sensitive assets including real estate investment trusts, commodities or TIPS. Last quarter Fidelity also tacked on floating-rate debt and real-estate debt as asset classes, said Joe Cullen, institutional portfolio manager at the Boston-based firm.
The proliferation of investment choices has made it harder for employers to shop for the best plans.
“It's getting more and more difficult for employers to vet target-date funds,” because there are so many variations with little track record, said Mark Wayne, CEO of Freedom One Financial Group. It's especially tough for small businesses with fewer resources, said Mr. Wayne, whose Clarkston, Mich.-based firm advises companies with 100 to 1,000 employees on 401(k) plans.
“This is going to be their sole retirement vehicle,” said Robin Diamonte, chief investment officer for United Technologies Corp., which uses a customized target-date fund as the default investment when automatically enrolling new hires in its 401(k) plan. “We think it's extremely important to get it right.”
The maker of Sikorsky helicopters and Otis elevators has about 100,000 participants in its 401(k) plan with about $16 billion in assets, of which about $1 billion was held in target-date funds as of January.
