Use target date funds the right way
Given last year's investment results, especially in 2010 target date funds, there are many who question whether the target date fund concept itself is fatally flawed.
Given last year’s investment results, especially in 2010 target date funds, there are many who question whether the target date fund concept itself is fatally flawed.
The answer depends on how one defines success.
In the popular press, success is defined as meeting participants’ expectations. This question strikes at the heart of one of the greatest risks in having plan participants default into any investment solution, namely the unspoken assumption that the plan sponsor’s choice of default will allow the worker to achieve retirement income security.
Indeed, the Pension Protection Act of 2006 specifically directed the Department of Labor to outline requirements for qualified default investment alternatives precisely for this reason — the fear that participants would be unable to retire because prior default choices (stable-value and money market funds) generated insufficient returns to provide for retirement security.
We think that the right way to define target date fund success is to focus very carefully on exactly what the plan sponsor is trying to accomplish, and then define or identify the target date fund approach most likely to achieve success for that plan. In essence, this means taking a defined benefit approach to the problem.
Such an approach involves three key elements: defining an objective for the funds (essentially, a definition of success); defining a time horizon for the investment; and understanding what cash flow will be coming into and out of the fund.
All three steps are extremely important, but hundreds of conversations about target date investing with plan sponsors over the past five years demonstrate to me that defining success is the most critical.
Simply stated, defining success means articulating what the target date funds should achieve. Broadly speaking, there are two goals a manager or sponsor can pursue: maximizing the upside or minimizing the downside.
As managers, we define our objective as maximizing the number of participants who reach a minimum level of income replacement. We aren’t aiming for the highest balance, because we know that in seeking higher returns, we are also adding risk and the chance of greater failure.
Instead, we try to get the highest number of individuals over the finish line safely.
But not all plan sponsors have the same objective.
Fortunately, the broad range of target date funds allows plan sponsors to match their objective to that of a provider. But if neither the plan sponsor nor the fund manager has articulated an objective, finding a good match is pretty tough.
In defining a time horizon, there has been a lot of discussion around whether funds should take participants “to” retirement or “through” retirement, and the relative merits of each approach.
As the Labor Department and the Securities and Exchange Commission indicated in recent hearings, the main difference between “to” and “through” strategies is in the assumptions around what happens to the bulk of participant assets in the plan. The question is whether participants will leave the target date fund, in which case the “to” approach is probably the best fit, or remain in the plan, so that the “through” approach is most appropriate.
Clearly articulating how the glide path works, and then allowing plan sponsors or advisers to choose the fund that best matches their plan’s needs, is critical.
Finally, cash flow. In developing our target date funds, we thought it was important to factor in observed cash flow — the real-life way participants put money into and take it out of their 401(k) plans.
We thought that would make more sense than making assumptions about how people behave or, worse, managing money based on how we thought participants should behave. It turns out that participants save less and take out more in loans and distributions than most people assume.
Following these three steps helps plan sponsors and their advisers identify the best target date funds for their plan and participants. It also helps them evaluate their target date funds’ success, especially in challenging markets.
Since unmet expectations, re-gardless of market conditions, are always a risk when there is a default option, clearly defining and communicating the target date fund’s objective is critical. As Yogi Berra said, “You’ve got to be very careful if you don’t know where you are going, because you might not get there.”
Anne Lester is a managing director and portfolio manager of the SmartRetirement Funds at J.P. Morgan Asset Management in New York.
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