Target date funds: Adviser’s checklist

Target date funds should be a panacea for in-vestors and advisers. Professional management, coupled with a preprogrammed asset alloca–tion glide path to accommodate in-vestors’ changing wealth, risk tolerance and liquidity needs, should make investing for retirement easier and more reliable. But a creative concept with clever packaging does not automatically produce a sound investment. By being mistaken for a retirement solution in a box for plan fiduciaries and participants, TDFs pose serious risks for both.

Conceived as a better default option than cash and propelled by the qualified default investment alternative provisions of the Pension Protection Act of 2006, TDFs have skyrocketed in popularity. There are now more than 20 million participants and $800 billion invested in TDFs. Nearly three out of four 401(k) plans offer them, according to a December 2013 study by the Employee Benefit Research Institute and the fund industry. And TDF assets are projected to reach $4 trillion by 2020.

One only has to look back to the 2008 crisis, however, to see that TDFs are anything but a one-size-fits-all solution that can be set and forgotten. Seemingly identical 2010 target date funds suffered wide-ranging losses that year, from 9% to 41%. Morningstar Inc. data from 2012 continued to show considerable differences in glide paths. For example, the 2011 equity allocation in 2010 funds ranged from 20% to 70%, and from 38% to 95% in 2050 funds.

DUE DILIGENCE

For fiduciaries under the Employee Retirement Income Security Act of 1974, these inconsistencies demonstrate why due diligence with TDF options is just as important as it is with other types of investments. The good news is that performance records are getting longer. Just over five years ago, only 11 TDFs had three- and five-year performance histories; that number is now at least 37.

In addition to standard due diligence on the underlying holdings, the investment fiduciary’s checklist should include factors relating to the manager’s philosophy and practices regarding portfolio composition, and strategic and tactical asset allocation. These include the use of active versus passive funds, correlation among holdings, glide path trajectory, volatility of the TDF’s returns over time and whether a “to” versus “through” approach is used.

Other questions the adviser should ask in a due diligence process:

• Do the characteristics of a particular fund align with plan demographics or to an individual’s risk tolerance and retirement readiness?

• Are the fund’s active managers truly active or are they closet indexers?’

• Is the net expense ratio of the TDF significantly higher or lower than the current average of 83 to 84 basis points?

As a result of the disparity in 2008 losses, regulators have placed TDFs under the microscope and are likely to require new disclosures around the fund labels and glide path asset mix in the near future. A volunteer committee went even further last year, recommending that the Securities and Exchange Commission also consider adding a standardized measure of fund risk for comparison between funds with the same date.

STANDARD RISK MEASURE

The pending regulatory disclosures should make due diligence somewhat easier for advisers. However, whether there will be a required standard measure of risk remains a topic of debate. When the SEC and Department of Labor reopened their coordinated rule makings on TDF disclosure to ask that question, the fund industry, asset managers and broker-dealers vigorously objected, pointing to the absence of an accepted measure. Meanwhile, consumer groups, state securities regulators and institutional investors supported the move.

The risks inherent to TDFs relate to variables that can affect retirement income readiness. These include ineffective asset allocation, poor performance of underlying funds, market risks of the asset classes represented, accumulation risk (not saving enough), longevity risk (living too long) and inflation.

The SEC has given a ballpark deadline of March 2015 for finalizing its disclosure rule. In the meantime, advisers shouldn’t underestimate their clients’ or plan participants’ potential for confusion. Studies have indicated that a sizable minority think the funds are guaranteed after the retirement date. And in one education session for participants, a pension adviser reported that some workers thought a TDF was an investment in Target — the big-box retailer.

Blaine F. Aiken is president and chief executive of fi360 Inc.