GuidePost - Vol. 4, Issue 5 2008

The GRABot BAG
by Sherrie E. Grabot, CEO

June 2008
Shortcuts to Nowhere

It’s human nature to look for a shortcut. Do I have to exercise and eat well, or can I just take a pill? Do I really have to prepare for that meeting? Can’t somebody else write this column?

For some questions of this kind, there is an easy way out. But in most aspects of life, such as retirement investing, there are very few true shortcuts. For example, I’ve been asked a few times recently whether target-date funds offer retirement plan participants a solution that works nearly as well as managed accounts, but with less effort, easier management, and perhaps lower fees.

Following are some of the pros and cons. But if you really want a shortcut, here’s the answer: “No.”

One size does not fit all
The hottest ticket in retirement investing these days is target-date funds. Call them what you will – lifecycle funds for the marketing-oriented, or asset allocation funds for the technical – the market for these products is experiencing rapid growth. Assets under management are exploding by 60% to 70% per year, and the sheer number of them is proliferating as well.

Until recently this was largely a retail phenomenon. To those of us in the retirement plan business it was of interest mainly as a welcome sign of progress in the outside world. But with target-date funds cleared for use as qualified default investment accounts (QDIA) for automatic enrollment, that is changing.

It’s no longer a question of whether target-date funds provide an acceptable one-stop solution for typical consumers trying to figure out retirement on their own. (That answer was “yes.”) Instead, responsible people are now asking if these funds might be an effective substitute for managed accounts within a retirement plan. There are several aspects to consider here, but they all add up to “no.”

It’s all about you
The most significant drawback of target-date funds is that they consider only the maturity date of the fund – not the actual characteristics of the investor.

In theory, an individual chooses a target-date that approximates their date of retirement. The fund managers will then follow a predetermined “glide path” toward that date, gradually shifting the balance toward more conservative, liquid assets as retirement approaches.

The problem is, the fund doesn’t “know” if an individual is planning to retire at age 60, 75, or somewhere in between. That extra decade or two can more than double the duration of retirement, and the length of time the money will have to last. An investment advisor or a managed account would adjust the investments accordingly, using age and actuarial data to manage toward the end of retirement, not just the beginning. For someone planning to retire early, the glide path of a typical target-date fund is probably much too conservative.

Need for speed
Other individual factors can also have significant consequences. If you buy into a fund with target date ten years out, the mix will be fairly conservative to start with. This makes sense if you’ve already accumulated substantial assets. But what if you’re behind on your savings and trying to play catch-up?

An actively managed solution would recommend an aggressive approach, risking greater volatility to gain higher returns. Target-date funds offering different flavors of risk for a given date are beginning to appear, perhaps in response to this concern. But asking investors to estimate their risk tolerance and click a button is not the same as using hard numbers and computer simulations to recommend an investment strategy.

Fasten your seat belts
Of course, a true investment strategy includes more than just balancing risk and return. Which brings us to the next important consideration that isn’t included in target-date funds: savings rate. Even if a fund happens to be optimal for your retirement date and retirement age (not the same thing!), and the level of risk is appropriate for your situation, it can’t meet your needs if you don’t save enough money in the first place. And the sad truth is, many retirement plan participants don’t save nearly enough. As a JP Morgan study tartly put it, “conventional wisdom with regard to participant behavior is fatally flawed.”

It’s not the fund’s fault, of course. Setting the savings rate is an individual decision, or at best, part of a structured advice process of some kind. But along with key information about age, risk, and assets it’s one of the major variables that should guide any investment plan. Approximating an asset-management glide path based on a date alone is much better than nothing. But it’s rather like pointing your airplane toward your destination – without knowing your airspeed, altitude, or how much fuel you have in the tanks.

Read the fine print
Other concerns have been raised about the underlying assets involved, not the target-date concept itself. Some observers take issue with the broad range of investments that are starting to appear in these funds: not just standard classes of stocks and bonds, but real estate trusts, commodities, emerging markets, and so-called inflation-protected securities. These products are professionally managed by reputable companies, and mirror the practices of large pension funds. But to many the variety of assets seems uncomfortably cutting-edge for their retirement savings.

Fund quality can also be an issue, as underperforming private-label funds can easily be slipped into the mix. In fact, many target-date offerings include only funds from within the provider’s own product range. In-house “rebundling” can actually be more expensive than a managed account that uses the fund options in the plan. As this segment continues to grow, more transparency would definitely be appreciated.

The bottom line? Choosing a target-date option is much better than the usual default method: fund-picking based on brand and past performance. This approach not only lacks any kind of built-in asset allocation, but it often leads investors to “buy high.”

However, target-date funds are no substitute for a disciplined strategy that considers all the personal and financial variables that make each investor unique. Almost by definition, there can be no such shortcut. So eat your vegetables, get some exercise, and be sure to rebalance your portfolio regularly…

~~ Sherrie