A review of target date funds and glide paths
Let’s talk about the target date funds inside employer retirement plans. The target date funds offered within an employer’s plan typically span the years from 2010 to 2060, and individual participants must select the correct fund to utilize. As a rule of thumb, most employees may be expected to retire around age 66 or 67, so they generally ought to select the target date fund vintage which coincides with that date.
For example, employee John Doe works at Acme Computers, which utilizes the Dallas Target Date Fund series in the 401(k)-investment lineup. Since John is 35 years old, he is probably going to invest in - or get automatically enrolled into - the Dallas 2050 Target Date Fund, since 2050 is close to the year John turns 67 years old. At present, the 2050 fund has a high level of equity and lower level of fixed income, 75% and 25% respectively. As John gets older, the 2050 Target Date Fund methodically reduces the underlying amount of equity (i.e. stocks) in the fund and correspondingly increases the amount of fixed income (i.e. bonds) in the fund. When John is younger, he should take advantage of the higher expected rate of return in equities, especially since he has the time to absorb the volatility inherent in the stock market. As John gets older, he loses the ability to withstand and recover from sharp or prolonged stock market corrections, so an ever-increasing proportion of his money gets converted into fixed income. While the fixed income allocation in his retirement fund shouldn’t be expected to generate as much return as the equity allocation, it should do a better job at preserving the capital he’s built up over the years.
In investor parlance, the proportion of equities within each fund inside a target date fund series is called its glide-path. While every target date series is a little different (with different underlying managers, initial and ending weights of equity, different rates of change, etcetera), each of them follows the same basic principle: As people get older, the amount of equity in their target date fund falls as those assets are converted to less volatile holdings, namely cash and bonds.
Every target date fund series follows this logic to a point. However, as you will shortly see, there is a point where this logic seems to break for certain target date fund providers.
The logic breaks
Let’s consider another employee at Acme Computers – Michael Smith. Michael is older, 65 years old in fact, so he invests in the Dallas 2020 Target Date Fund. Michael plans on working another year or two, and deferring his retirement until he is 67, so he will keep his retirement assets in the company plan for a few more years.
The Dallas Target Date Series is a “to-retirement” series. In other words, the 2020 fund has reached its terminal state and will not change its equity allocation after the retirement date. In contrast, a “through-retirement” target date series continues to lower its proportion of equity for a number of years past the retirement date. By this late date, the Dallas 2020 Target Date Fund has steadily reduced its proportion of equity for many years, and now the fund has bottomed out at its final target of 20% equity & 80% fixed income.
To this point, everything has occurred more or less according to plan, but now something odd is going to become apparent. As individual funds in the Dallas target date series reach their retirement date, they shut down and divest the fund assets into a different fund – the Dallas Retirement Income fund. As you might expect, the Dallas Retirement Income fund is the repository of all the assets in the 2020 fund, but it has also been the final repository of previously wound up funds like the 2015 and 2010 vintage funds. As a result, the Dallas Retirement Income fund represents a disproportionately large amount of Acme Computer’s retirement plan assets. First, the old vintage funds represent the decades of compounded accumulation by the employees. Second, even though assets are continually withdrawn as employees pay for their retirement, the fund is continually replenished every 5 years as another vintage winds down and diverts its assets into the income fund.
Recall the 2020 fund (and all previously unwound target date funds) finished their investment plan with the conservative allocation of 20% equity / 80% fixed income. You might think, logically, that the Retirement Income Fund underlying allocation would be equally conservative or even more so. It is not. Strangely, the Dallas Retirement Income fund places a greater proportion of the fund’s underlying value at risk, with a 35% equity allocation and 65% fixed income allocation. Let’s not forget that this undue level of stock market risk is being borne by retirees – some of whom are a full decade into retirement; they can least afford a dent in their nest-egg and they have the least amount of time to recover from an untimely recession or market pullback. Let’s also remember that the actual dollar values at stake in the Retirement Income fund are disproportionately high. Put simply, this situation is a problem.
Given the generic names we are using like “John Doe” and “Acme Computers”, you might be forgiven for assuming this is a hypothetical problem which doesn’t actually exist in the real world. Sadly, this problem is real. This situation is happening right now across common target date fund providers.
How could this happen? To explain, here’s what happened specifically in the case of Dallas Investments target date series. While target date funds are extremely popular and heavily utilized today, the actual development and proliferation of target date funds is only twenty years old. For decades, target risk funds – ranging from Conservative, Moderate, and Aggressively allocated funds – were the gold standard for balanced fund and retirement planning. In fact, Dallas Investments maintained a set of target-risk funds for retirement plan clients for decades, but their target date solution was only created within the past twenty years. Rather than creating the target date series from scratch, they merged and integrated the existing target risk series, where fund allocations remain stable over time, into the brand-new target date series. The underlying problem was that the most conservative target risk funds had a relatively high equity allocation. Their conservative target risk fund was not conceived as the most conservative possible repository of assets; it was still designed to provide some meaningful equity returns over a lifetime of use whereas a retirement income fund is meant to defend its value against inflation losses and stock market pullbacks.
Dallas Investments have been trying to integrate these funds, but it can’t happen overnight. Over time, they have reduced the equity allocation of this fund, but they couldn’t reduce it to an appropriately low equity endpoint – 15% equity is the ultimate goal – without impacting their existing client’s long-term strategic outcome. Over time, the original asset holders have been merged, slowly and surely, into a lower equity allocation with years of announcements, disclosures, preparation, and risk management along the way. However, this came at the cost. New money and near-term retirees utilizing the retirement income fund have borne inappropriately high equity allocations and an inappropriate level of risk.
At the current rate of change, it is going to take another decade for the equity allocations of the oldest vintages and the retirement incomes to match. It’s going to take even more time for the equity level of the income fund to cross into the intended target range of equity (15%) set by Dallas investments. For the interim, new investors in the fund may feel meaningfully double-crossed by the illogical nature of the particular (and, it bears repeating, exceeding popular) target date series.
More problems with retirement income and equity weights
On a positive note, most retirement income funds were created from scratch as part of an independent target date series and do not have this problem. But that doesn’t mean retirement income funds should be free from additional scrutiny.
Let’s consider the totality of the category. At present, there are 190 different mutual funds in the target date retirement income category. Once you strip away duplicated strategies across different mutual fund share-classes, we determine there are currently 42 distinct retirement income funds with a maximum equity allocation of 44% and a minimum equity allocation of 9%.
That is an absurdly high range. Given the very high range of allowable equities, it’s clear that a fund with 44% equity will not perform anywhere close to a fund with only 9% equity, but they’ve been placed in the same category. In contrast, investment analysis firms (like Lipper, Morningstar or Thompson Reuters) typically separate balanced funds based on 20% equity increments. For instance, they might create a category for balanced funds which have combined equities of 40% to 60%. They might create an entirely separate category for balanced funds with combined equities of 20% to 40%, with an entirely different set of index and peer benchmarks. This is a reasonable solution which attempts to fairly evaluate peers.
The retirement income category, sadly, does not fairly evaluate similar peers. For example, given last year’s tremendous equity rally (where equities broadly outperformed fixed income by 25%) you could mathematically expect the high equity retirement income fund to outperform the low equity retirement income fund by 8.75% based on the allocation effect alone. These two funds are not truly peers and they shouldn’t be regarded as comparable, but they are.
Like many issues regarding the eccentricities of target date fund series, the solution is enhanced due diligence. There is not necessarily anything wrong with either investment strategy. One client might select a target date series with very steep “glide-path” with low terminal equity allocations while a different client may prefer a gradual, shallow glide-path which retains moderately high levels of equity throughout the retirement date. However, it is critical to understand which type of strategy your employees have signed up for and if it coincides with investment behavior near retirement. Enhanced due diligence and documentation of this thought process is a necessary element when selecting the target date solution for your plan.
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