W. Scott Simon
In last month’s column, I revisited the discussion in my January 2016 column about target-date retirement income funds first made available by Dimensional Fund Advisors in late 2015. This month, I’m taking a look at target-date funds and will explain why they are suboptimal to target date retirement income funds.
A target-date fund is a “fund of funds” structure. It provides participants in defined contribution plans such as 401(k) plans with a “do it for you” investment solution by which they invest in a portfolio of stocks, bonds, and other investments. As a participant gets older and older, the manager of the target-date fund changes the target-date fund’s asset allocation–called a “glide path”–by reducing more and more the portion of the target-date fund portfolio invested in riskier investments such as stocks and increases the portion in less risky investments such as bonds.
The manager of a typical target-date fund seeks to grow nominal (stated value, unadjusted for inflation) wealth while also attempting to manage the volatility in value of a plan participant’s nest egg. Given the well-diversified nature of many target-date funds as well as their simplicity, many plan sponsors include them as their plan’s qualified default investment alternative. When plan participants fail to tell a sponsor in which investment option(s) they wish to invest their accounts, the sponsor will “default” a participant’s account into the plan’s designated QDIA. The fact that target-date funds are relatively easy to understand, offer ease of use, and are well diversified makes them appealing to plan participants who don’t want to engage in managing their retirement accounts and to plan sponsors who want the safe harbor of a QDIA.
By retirement (that is, by the target date), a target-date fund seeks to “de-risk” its portfolio in wealth terms–to a greater or lesser degree depending on the target-date fund’s asset allocation at that time–in the sense of reducing the volatility in value of the portfolio’s investments. A target-date fund is de-risked to a greater degree usually when its glide path is based on the “to” retirement approach. The portfolio of a target-date fund using this approach is at its most conservative at the point of a participant’s retirement– the target date. A target-date fund is de-risked to a lesser degree usually when its glide path is based on the “through” retirement approach. Such a target-date fund must necessarily wait to achieve its most conservative asset allocation some number of years into retirement–that is, through the target date. For example, a 70-year-old retiree in a through target-date fund may have its account balance invested in, say, 40% stocks for some years even after retiring.
This brings to mind the heated debates that broke out after the 2007-2009 stock market downturn in which target-date fund providers and their critics endlessly squabbled among themselves over what should have been the “right” asset allocation–among a wide array of asset allocations–to get investors through the downturn relatively unscathed. For example, how target-date funds gradually de-risk their portfolios leading up to retirement–the target date–varies widely among the various target-date fund providers. Some would argue that many target-date funds are invested too heavily in stocks prior to retirement. This can result in inadequate protection against “sequence risk” in which a plan participant on, say, the day of his or her retirement slept in past the close of the market, only to wake and find that their portfolio had declined in value by over 20% on a single day in October 1987. That’s what puts the “R” in risk.
These debates were just a different riff on the same old story of (expensive and risky) active investment management and its stock-picking, market-timing, track record investing, etc., all predicated on the assumption that it’s possible to accurately predict the future. They were/are really no different than the lament after every downturn that “diversification didn’t work” and that if only investors had been invested in the pet portfolios (constructed after the fact of a downturn, of course) of the particular lamenting commentator, all would have ended well. 20/20 hindsight is a wonderful thing but regular readers of this column know that it holds no truck with the legal standards of modern prudent fiduciary investing.
The debates over the wisdom of what should have been the “best” asset allocations in target-date funds, however, are irrelevant, and here’s why. Managers of target-date funds tend to focus primarily on attempting to grow nominal (stated value unadjusted for inflation) wealth while also attempting to manage the volatility in the value of the investments in a target-date fund’s portfolio. This focus on wealth accumulation occurs during the “savings phase” of a plan participant’s working years.
But target-date funds wholly fail to address wealth “decumulation” (or perhaps a more user-friendly–or not!–word, de-accumulation), which is a participant’s “spending phase” during retirement. Decumulation is the process of taking a (large, middling or small) retirement lump sum and, through the deployment of an array of investments, turning it into a reasonably stable, inflation-adjusted and sustainable income stream throughout retirement. Decumulation is essentially the flip side of accumulation. Each process can be long term in nature.
The fundamental, underlying problem with most target-date funds, then, is that they focus primarily on the savings phase of retirement planning while ignoring the spending phase. This is reinforced by most target- date fund evaluators because they focus on one-, three-, five-, or 10-year performance and risk (standard deviation). That is, they evaluate target-date funds only in terms of how they treat accumulation, not how they handle both accumulation and decumulation. In my view, target-date funds really miss the boat in that they fail to solve the very real problem faced by all plan participants: the creation of a relatively stable, sustainable and inflation-adjusted income stream throughout retirement.
Target-date income funds are much better at solving this problem because they address the relevant issues. The risks relevant to experiencing a stable and sustainable retirement income are unexpected changes in stock markets, inflation, and interest rates. In order to manage these risks prior to retirement, target-date income funds gradually decrease exposure to stocks (reducing market risk) while transitioning to Treasury Inflation-Protected Securities that hedge for inflation (the built-in inflation adjustment of TIPS) and interest rates (duration-matching). Target-date income funds take into account both the savings and spending phases including managing the risks that can pose a significant threat to income during what (hopefully) will be a long, enjoyable and comfortable retirement. This can lead advisors into meaningful discussions about the implications of retirement wellness.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.