Target-Date Funds Examined

Not enough time Tuesday afternoon to give this the full treatment (in part because Typepad just ate the first version of this post, which, yes, is a problem that's easily overcome with a preemptive copy-and-paste... but still... very annoying). But we ran across two interesting pieces on target-date funds, which have been frequent topics of discussion in this space for three primary reasons:

1. They're increasingly prominent features of defined-contribution plans, and thus increasingly important ingredients in the future retirement security of millions of Americans.
2. Like 401(k) plans themselves, target-date funds are loaded with potential... and plagued by a few non-trivial (and easily avoidable) shortcomings, most of which can be traced back to non-fiduciary practices in the financial services industry and lack of awareness among sponsors and participants.
3. Whenever fund companies get excited about selling a particular type of product, it's time to add an extra layer of vigilance.

We'll have some analysis of these two pieces as soon as time permits (tomorrow morning's looking good from here). Until then, both are worth a few minutes of your time if you're interested in such things: "Twelve observations on target date funds" and "New Study Finds Target Date Industry Has Serious Shortcomings."

Comments

[SmartETF:]

Target date funds and Lifestyle funds are the great marketing hoax of the decade. They assume long-term historical trends make good investment strategies and that bonds are safer than stocks; these are only several of the many faulty assumptions.

If these funds existed in 1960 your recommended asset allocation mix, per age, would look very similar to the mixes recommended today. Over the next 20 years those accounts would have been devastated as interest rates sky-rocketed (killing bond prices) and stocks plummeted; both due to hyper-inflation. No combination of stock and bonds would have delivered positive results; in fact, it would have taken another decade for your portfolio to get above water had you invested at the top of the market in 1960 (in other words 30 years).

This market just completed the longest bull market run in America’s history and these models refuse to believe it’s over because they look at past performance to predict future results. If you haven’t noticed the market is down over a 10 year time frame; how accurate are those assumptions?

The logic of target-date funds is flawed. Target-date funds assume younger investors should be weighted more heavily in equities since they have more time and older investors should be invested more in fixed income. Let’s examine this year, the market tanks and your younger investors are getting crushed, why is that a good thing? A 20% drop requires a 25% increased to break-even. Some day, in the not to distant future, interest rates are going to increase and older investors will get laid away as their portfolio values plummet. Why is that a good thing? They might not have 30 year to break-even. Investors will no meet or exceed their targets or meet their lifestyle needs except in bull markets.

A study by Elton, Gruber & Blake in December of 2004 determined that 63% of all 401(k) plans failed to offer enough fund choices to properly diversify a portfolio. They calculated the plan participants of these inadequate plans lost more than 300% of their terminal wealth over a 20 year period. This is a good argument for any kind of asset allocation model, including target-date/ lifestyle funds.

However, the reliance on antiquated mean-variance models is just as appalling as Wall Streets aversion to taking on the fiduciary responsibility. Placing the responsibility onto the heads of plan participants is the ultimate scapegoat from being an investment professional; shame on our industry. Our marketing engines are no different than our politicians; they practice the KISS principal by selling to the lowest common denominator (low lowest IQ). Don’t think Clinton, Bush, or Obama speak to their peer group the same way they speak on TV. Do you think Bush keeps repeating to his son “Stay the coarse” when he gets in trouble or Obama constantly tells his wife “We need a change”. Wake up America and see you are being sold another faulty product from the marketing departments of the financial industry.

2008 Jul 16 02:14 PM