Ask an Expert - Target Date Funds

While assets continue to flow into all the primary QDIA options, the flows have slowed recently.  This decline can be partially attributed to plans shifting from mutual fund solutions to collective trusts or custom target maturity solutions.  Once shifted, the assets are no longer included in the mutual fund figures.  Based on year end data, we would estimate that non-mutual fund assets held in Target Maturity Funds were about 11% of the total.

Unlike Target Maturity Funds in which  the overwhelming majority of assets are held in mutual funds, Target Risk Funds tend to gather a large percentage of assets in non-mutual fund investment vehicles like separate accounts and collective trusts.  As a result, we would estimate that  about half the assets currently held in Target Risk Funds are in non-mutual fund investment vehicles.

Like almost all mutual funds and similar investment vehicles, target date funds contain varying degrees of market risk.  Recent declines are directly related to the amount of market risk in the target date fund.  For example, a typical target date fund that currently invests approximately 50% in equities is off just about as much as a typical target “risk” or balanced fund that invests approximately 50% in equities.  These have been extraordinarily unfavorable times and target date funds have not escaped the systematic deleveraging of all assets.

There is a common misconception that all target date funds with similar retirement dates follow a similar investment strategy. In fact they are meaningfully different.  This variation is poorly communicated to investors and advisors, which results in a lack of understanding of how to select an appropriate target date fund.  

Investors and advisors generally select a target date fund based on the investor’s age from their favorite fund family, a far too simplistic approach.  Typically funds within the same category, like U.S. large value funds, share a similar investment strategy and can be compared to each other based on factors like fees and track record. However, many target date funds with the same stated retirement date follow significantly different investment strategies. Thus, prior to comparing funds based on fees or track record, it is necessary to narrow the ever-increasing universe of target date funds to those that are following investment strategies that are appropriate for a specific investor.  As such, investors and advisors need to determine which target date strategies (mostly how much is invested in equities) are most suitable for them, taking into consideration the investor’s financial situation (risk capacity) and preference for risk.  For more details, see the Ibbotson Target Maturity Report – Third Quarter 2008.

The benchmarking of target-date funds is a difficult, but important challenge. Fortunately, innovative target-date benchmark families will be available shortly that will help advisors evaluate the performance of these funds.

As the question points out, the funds are all over the map on a variety of issues, which presents benchmarking and performance measurement obstacles. Two such issues are the split between stocks vs. bonds and the detailed intra-stock and intra-bond allocations. Other issues include the use of fund-of-fund managers vs. individual securities, whether to use passive or active managers and the use of a tactical asset allocation overlay.

Accountability demands that the industry provide a solution for this repository of retirement savings. Part of the solution requires greater transparency from fund providers and advances from those providing the benchmarks. Increased effort on the part of financial advisors will also be required.

The biggest driver of return differences between the funds is the evolving stock vs. bond split. In general, a target-date fund invests a majority of its assets in stocks early on. The fund generally shifts the assets out of stocks and into bonds as the investor ages. Some funds follow an aggressive stock mix or “glide path” while others follow a more conservative glide path. The key is to evaluate a given target maturity fund against a benchmark with a similar stock vs. bond split or risk profile. This approach requires a family of target-date benchmarks.

The suitability of an aggressive vs. conservative glide path depends on both the preference and capacity of an individual investor to take on risk. Advisors can play a key role in ensuring investors and funds are matched appropriately. Some of the analytic tools advisors can use to illustrate the differences between target-maturity funds are: Monte Carlo Simulations, Glide Path Comparisons, Detailed Asset Allocation Comparisons and Risk/Return Graphs.

Monte Carlo Simulation is a powerful tool for illustrating how funds with different glide paths and different intra-stock/intra-bond allocations should perform in the future. The difficulty today is finding a MCS tool that allows advisors to input an evolving and detailed asset allocation schedule.

Glide Path Comparison Charts illustrate the evolving stock vs. bond split of different funds. Glide path comparisons enable advisors to quickly evaluate how aggressive a glide path is relative to other glide paths.

Detailed Asset Allocation Comparisons illustrate how strategic features like large cap vs. small cap, growth vs. value, domestic vs. international and nominal bonds vs. inflation linked bonds differ across a universe of funds with the same target date. These comparisons can be made using software tools with holdings data. Reports that monitor the detailed asset allocations of the target-maturity universe are expected to be available shortly.

Risk & Return Graphs are a simple tool that advisors can use today to compare funds and gain insights into the underlying asset allocations. Plotting the performance of target-maturity funds with the performance of individual asset classes over a variety of time periods is recommended.