Do your target-date funds offer real or only illusions of value?
It is a question few fiduciaries have seriously considered. After all, Congress endorsed target-date funds in the Pension Protection Act of 2006 by making them a qualified default investment alternative.
TDFs are often black boxes, so many fiduciaries don't realize they do not have a rigorous conceptual basis — as demonstrated by the dramatic variation in the returns and asset allocations of funds with the same target date.
For example, in reporting the total returns (as of Dec. 31, 2012) of funds with a target year of 2015 from the 32 largest TDF families, Morningstar Inc. found the one-year returns ranged from a low of 1.8% to a high of 13.81%. The funds' three-year annualized returns ranged from 4.19% to 8.98%. During this period, the average equity allocation for these funds ranged from a low of about 10% to a high of about 65%.
In 2013, believing that all too many fiduciaries were ignoring the significance of the variations, the Department of Labor published guidelines for fiduciaries to consider in “Target Date Retirement Funds — Tips for ERISA Plan Fiduciaries.”
The U.S. Court of Appeals for the 4th Circuit, Richmond, Va., in its decision this year on Aug. 4 in Richard G. Tatum vs. RJR Pension Investment Committee et al., reminded fiduciaries of the need to document carefully all their decision-making processes, including how their decisions affect participants' retirement security.
To help fiduciaries assess the thoroughness and the adequacy of their documentation of their processes for selecting, monitoring and communicating TDFs, fiduciaries should ask themselves how quickly and in what detail they could respond to the following letter from a participant.
Four years ago, I was auto-enrolled into the 401(k) plan and defaulted into the 2040 TDF. Rather than accepting the default contribution rate of 3%, I increased my contribution rate to 6% so I could receive the full matching contribution.
I tried using the retirement planning calculator on the plan's website to determine whether I should increase my contribution rate. The calculator required entering assumptions that were neither in the participant communications nor available from our 401(k) manager, plan call center or TDF's investment manager.
Out of desperation, I called my cousin, a Ph.D. in finance. He said he could provide assumptions, but he felt strongly that we should compare his assumptions and the contribution rate generated from them with the contribution rate generated from assumptions derived from the TDF's glidepath.
In arriving at a glidepath, my cousin pointed out, the investment manager uses a hypothetical participant. The manager assumes a starting age, a starting salary, an annual salary growth rate, a retirement age, a contribution rate (either a constant one or an escalating one), a life expectancy, a post-retirement inflation rate, and a targeted replacement ratio. Without this information, I can't tell how close a match I am to the investment manager's hypothetical participant.
Once the overall glidepath is created, the investment manager can calculate both the pre- and post-retirement annualized compound returns he expects the glidepath to generate for each TDF in the series. Participants need these rates and the assumptions used in creating the glidepath (or ones that more accurately reflect their circumstances) in order to calculate an appropriate contribution rate.
My cousin believes the 401(k) committee must have all the assumptions. He suggested I learn how the 401(k) committee approached the following issues, believing an understanding of the fiduciaries' reasoning would assist me in determining whether I felt the default option would likely fulfill my needs:
- Attempting to compare TDFs with the same target date seems more like trying to compare apples and oranges rather than comparing funds that profess to have the same goal — helping participants (assuming they make adequate contributions) achieve a comfortable retirement income by providing them with a diversified and appropriate asset allocation scheme throughout their working and retirement years.
- Fiduciaries and the quants who create TDFs routinely confuse the elegance of the mathematics and the statistical techniques (including Monte Carlo simulations) on which their models are based with the models' abilities to predict future events. Fiduciaries and quants often ignore the reality that as financial markets change, the usefulness of their assumptions goes by the wayside.
- The glidepath is supposedly designed to minimize the likelihood of large losses close to retirement by systematically reducing the portfolio's allocation to stocks. This approach, however, can lock in large losses or inadequate assets due to the failure of the fund to achieve its anticipated pre-retirement growth rate that occurs close to or in the years preceding a participant's anticipated retirement date. Returns below expectations occurred in the first 10 years of this century, when equities grew in the low single digits. In other words, if the stock market rebounds after a bear market, doesn't it make sense for the glidepath to be restructured so as to enable participants to attempt to get back on track?
- Our TDFs' design does not appear to address tail risks or the need for risk allocation. Since both of these issues are hot topics among fiduciaries of large defined benefit pension plans and endowments, should they have been incorporated into our TDFs?
- Lastly, how does the 401(k) committee evaluate whether their choice of TDFs appear to be helping participants achieve a financially secure retirement? If the funds don't appear to be living up to expectations, how do the fiduciaries assess whether the problem is due to inadequate contributions, unfavorable capital markets and poor participant communications, or some combination of them?
Mr. Committee Chairman, I look forward to your reply.
What are fiduciaries to do? The Employee Retirement Income Security Act of 1974 does not require fiduciaries to have perfect crystal balls. Rather, ERISA and the regulations mandate fiduciaries make decisions as if they are prudent experts who thoroughly evaluated the issue at hand. Using a highly regarded investment manager or consultant is no justification for fiduciaries being lax in both their assessments and documentation.
In regard to whether a 401(k) plan's target-date funds offer real or only illusions of value, that is an issue fiduciaries must now take seriously.
Richard D. Glass is president of Investment Horizons Inc., Pittsburgh.