The Target Date Industry is too Aggressive

On the whole, target date fund companies leave too much of their assets in equities on the target date, exposing retirees to unnecessary risk.  TDA believes that, on the target date, 100% of assets should be in “safe” securities, either cash or fixed income.  Surz says “on the target date, advisors should be restructuring for the distribution phase, into annuities or other vehicles.”  He added, “the lessons of the last eight months are that advisors can pay a high price if retirement portfolios are not properly allocated as the target approaches.”

In fact, of the 38 mutual fund companies studied, none had an equity allocation of zero on the target date.  Allocations ranged from 20% to 80% of funds in equities, with a mean of approximately 40%. 

As an explanation for this phenomenon, Surz believes fund companies may be hoping retirees will keep their assets with the equity funds offered by the fund company once the target date is reached.  Alternatively, fund companies may be simply seeking to maximize revenue from equity funds and their higher management fees.

TDA measures Aggressiveness by comparing the asset allocation of each fund to a target asset allocation based on index funds.  It measures whether the fund outperformed the index allocation.  Of the 38 mutual fund companies covered in the study, only 14 have funds with three years of history, which is the minimum data requirement for TDA to calculate performance.  For these 14 fund companies, their Aggressiveness scores were uniformly high and positive for the last three years, resulting from the strong performance in the US equity markets and from the funds’ over-allocation to equities.

Advisors should not be reassured by the high and positive Aggressiveness scores.  They indicate an excessive level of risk in asset allocation, which is an industry-wide phenomenon.

Surz also notes that the 24 newer entrants into the target date industry are charging fees above the industry average.  He would have expected them to be more competitive with their fees in order to attract market share, and now worries that some fund companies see target date funds as an opportunity to cash in on high fees.

Funds Lack Diversification

TDA finds that the target date industry utilizes asset allocations which place too much emphasis on US equities, and fail to diversify adequately into non-US markets, as well as into alternative asset classes, like real estate and commodities.  To measure this, TDA calculates a Concentration measure, by comparing each fund’s asset allocation against a broadly diversified allocation.

Surz believes that funds have been sacrificing about 50 basis points in annual return due to this lack of diversification.  To explain this, he notes that the starting point for most fund companies was an allocation based on the S&P 500 and the Lehman Aggregate fixed income index, and the industry has evolved slowly from this point.  He says, “as the target date industry matures, portfolios will get more diversified.”

None of the 38 fund companies exhibited truly diversified portfolios.

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