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Oktoberfist: Digesting October’s Sucker Punch
By Ron Surz
November 11, 2008

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Target Date Funds

Unlike the dozens of U.S. stock indexes, there are only three target date fund indexes. Dow Jones introduced their indexes first, in April 2005. Then my firm, Target Date Analytics (TDA), introduced our indexes in October 2007. And Standard and Poor’s (S&P) just announced the creation of their new indexes. Plan Sponsor magazine adopted the TDA indexes in August of this year and re-branded them as the PLANSPONSOR On Target Indexes (OTI).

These three indexes differ substantially in composition and philosophy. Let’s discuss philosophy first:

  • The S&P indexes are industry averages, reflecting common practices among current target date fund offerings. S&P describes this construction as follows: 
  • Each index is representative of the investment opportunity available to investors for the corresponding target date horizon, with asset class exposures driven by a survey of available target date funds for that horizon.”
  • The Dow indexes have a stated objective to: “measure the performance of a lifecycle portfolio that seeks to grow and preserve real value over time.”
  • The PLANSPONSOR On Target Indexes have two objectives: “(1) Protect the purchasing power of contributions with a very high probability, and (2) Grow assets with a reasonably high probability, without jeopardizing the primary protection objective.”
  • The major difference between the Dow and OTI objectives is priority. Dow places equal emphasis on preservation and growth whereas OTI emphasizes preservation over growth. In summary, the OTI and Dow indexes are standards – the way target date funds should be managed – and the S&P indexes are common practice aggregates. Unfortunately, we find common practice woefully lagging both the Dow and OTI standards. Target date funds are a great idea with awful execution, at least so far.

These differences in philosophy and objectives lead to materially different index compositions and results. The following exhibit summarizes composition differences at the broad equity allocationGlide Paths level. As you can see, as the target date approaches the S&P indexes are the most aggressive, followed by the Dow, and then the PLANSPONSOR OTI are the most defensive.  All 3 indexes are quite similar in equity allocation at the more distant dates.

There is an ongoing debate raging in the target date industry regarding the purpose of target date funds. So far it’s TDA versus the industry. We at TDA believe that target date funds should be limited to the accumulation phase of a participant’s lifecycle, and that the distribution phase is best served by vehicles designed for this purpose, like annuities.

Vehicles designed to address longevity risk should be employed post-retirement because there is no glide path that can handle this life-long task.

Accordingly, we believe that target date funds should be entirely in safe non-risky assets at target date, waiting for the participant to move to the next phase, which they should be thinking about long before retirement. But the industry doesn’t see it our way. The target date fund industry sees target date funds continuing beyond the target date. Some see accumulation funds morphing into distribution funds at target date and continuing on, in some cases to death. This is akin to viewing the target date as a small speed bump on the highway of life. Truth in advertising dictates that funds taking this extended view should be re-labeled so the investor knows their intended lifespan. For example, 2010 funds that are intended to serve the investor for 30 years beyond retirement date should be re-labeled 2010-to-2040 funds. But not all fund companies extend their glidepaths. Some fund companies roll their target date funds into “Income Funds”, which have the objective of throwing off reliable income while preserving principal, rather than managing longevity risk. Both approaches extend the investor’s participation beyond target date. What do you think the role of target date funds should be? Should they continue beyond target date?

These composition and philosophical differences have significantly impacted target date index performance in the year to date, as shown in the next exhibit. The recent meltdown has been a wake-up call for the target date industry and gives TDA an “I told you so” that we wish we didn’t have. Our greatest concern is for investors in near-dated funds, who are at or near retirement, and have the most at stake both emotionally and monetarily. For the most part these 60-plus year old investors are in target date funds as a default option in their 401(K) plans, since target date funds are one of three qualified default investment alternatives (QDIAs). Do you suppose any of these folks were prepared for the kind of disastrous loss that has occurred in both the S&P and Dow indexes? Did they know the risks they were exposed to? That is, what is the better standard?

Target Date Index

(S&P returns are approximate, and represented by TDA’s peer group indexes.)
        
Your choice of index makes a big difference in your evaluation of target date fund results. Choose the index that is most in line with the plan participants’ understanding of what target funds should be.

Conclusion

These have been trying times, and may be a harbinger of more to come. As long as we’re paying the price, we might as well learn as much as we can from the lessons of these markets.
Here are a few lessons from this decrepit decade that can help us going forward:

  1. Investors are entitled to be concerned about recent capital market behavior. It’s been awful. “Staying the course” just hasn’t cut it, and might not going forward. But there’s a penalty for us all running to the door at the same time. The biggest risk we face is a panic-induced Pogo predicament: “We have met the enemy and they are us.” These are very tough decisions.
  2. Moving to certain styles, sectors or countries may help defend but hedging has worked best. Of course, investors can hedge on their own through the use of derivatives, or moving to cash.
  3. This is a good time to stress test managers for skill. You know that stuff about what the tough do when the going gets tough. But it is absolutely critical that the benchmark is accurate. Some will get fired for the wrong reasons, and then their replacements will get hired for the wrong reasons too. Clients need to know what a “fair” loss should be, given what the manager does. Hint: off-the-shelf indexes only work on index huggers.
  4. Selecting target date funds is currently problematic because this industry as a whole has entered into a performance race, and is exposing investors to too much risk, especially near target date. The timing for these moves to higher risk was bad, but it will be even worse if we don’t learn from this lesson: target date funds should defend better near target date.

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