See this year’s 401(k) Buyer’s Guide.
So much for autopilot. Amid all the recent tumult in the 401(k) space, one area that plan sponsors may have thought was trouble-free is anything but. Target-date funds — premixed portfolios that automatically get more conservative as an investor’s retirement date approaches — are marketed as an ideal way to simplify investing: all a participant has to do is specify his or her expected retirement year and the fund manager does the rest.
But for a plan fiduciary, choosing a target-date lineup is far from easy. The funds vary enormously from one provider to another — a fact driven home last year when some of the biggest losses were suffered by participants on the verge of retirement, who supposedly had the most conservative portfolios. The average 2010 fund (that is, a fund allegedly tailored to an employee due to retire in 2010) lost 23.3%. Some fared far better, with the best losing just 3.6%; but some fared dismally, with the worst-performing 2010 fund losing a stunning 41.3%.
These huge disparities underscore a poorly understood reality: target-date funds differ dramatically in asset mix and in “glide path” — the rate at which the asset mix changes over time. “Participants who rely on date alone to choose a fund can have much more exposure to market volatility than they realize,” says Tom Idzorek, chief investment officer and director of research at Ibbotson Associates, a Morningstar subsidiary. Indeed, the percentage of equities in 2010 target-date funds ranges from 14% to 65%.
Rediscovering Risk Tolerance
In February, Morningstar introduced a new rating system to make it easier to compare and benchmark target-date funds. The company has 13 target-date asset-allocation indexes available in three risk profiles — aggressive, moderate, and conservative. The index allocations adjust over time, reducing equity exposure and shifting toward income-producing and inflation-hedging asset classes. Morningstar has also now grouped the funds into five-year categories. Previously, they were lumped into three broad groups: 2000–2014 funds, 2015–2029 funds, and 2030+ funds.
“Now that everyone has rediscovered what risk tolerance means, plan fiduciaries may want to limit themselves to target-date funds with a more conservative glide path,” says Idzorek. The trade-off: a conservative fund may provide more-stable returns around the investor’s retirement date, but it won’t necessarily generate the growth needed to support decades of retirement.
In addition to risk tolerance, Idzorek advises sponsors to consider “the human-capital characteristics” of the plan population — that is, how likely is it that participants will need to tap their 401(k) savings long before their retirement dates? “Tenured university professors are better candidates for an aggressive [that is, riskier] glide path, given their secure employment, than are stock brokers, who face a more unpredictable career outlook,” he says.
A target-date family’s underlying components typically come from a single financial provider, and often include weak proprietary funds. (An object lesson: the Oppenheimer 2010 Target-Date Fund’s 41.3% loss last year was due both to its 65% equity allocation and to the fact that its core bond holding was heavily invested in mortgage-backed securities.) “If the plan sponsor thinks one or two of the underlying funds aren’t any good, there’s usually nothing he can do about it,” says Robyn Credico, national director of Watson Wyatt’s defined-contribution practice. “The financial provider decides what to put into target-date funds, and in what proportion.”