Will a target-date fund crash bury the boomers?

There’s a bull's-eye on the backs of target-date fund holders, and regulators had better rip it off before it’s too late.

Target-date funds suffered severe losses during the first half, even in the more conservative funds, as a result of the sell-offs in the stock and bond markets. 2020 funds (designed for those who will be in or near retirement between 2015 and 2025) have lost 15% year-to-date, while younger employees invested in 2060 funds (for those retiring between 2055 and 2065) have lost 20%, according to Ronald Surz, president of investment consultant Target Date Solutions.

Surz likens the current market environment to that in 2008, when TDFs, a default option in most defined-contribution plans, fell more than 30%. That severe downdraft elicited a joint hearing of the Department of Labor and Securities and Exchange Commission the following June — a hearing that ultimately accomplished very little in terms of tightening standards for TDFs.

TDFs held $200 billion in assets at the time of the Great Recession, compared with $3.5 trillion today. More disturbing, however, is the fact that in 2008 there were 78 million baby boomers not yet in what is often called the “risk zone," a period defined as the five to 10 years before and after retirement, when losses are not easily recovered. Those same boomers are now waist-deep in the risk zone, a danger that could prompt something bigger than a government get-together.  

“It’s starting to happen again, but this time will be far worse than 2008 because much more money and many more people are at risk, and losses are expected to be substantially worse,” Surz said. “The only thing that has changed since then is bonds have become riskier, with record low yields, so they no longer protect.”

Surz points out that most TDFs have a similar construction, generally ending at the target retirement date with an allocation of 50% in equities plus 35% in long-term bonds. Combining those two asset classes creates an unhealthy weighting of 85% in what he considers “risky assets.”

It also explains why 2020 funds have severely underperformed this year relative to the far safer 2020 fund of the Federal Thrift Savings Plan, which holds 70% of its assets in TSP's Fund G, which invests in securities guaranteed by the U.S. government.

The TSP G Fund allows investors to earn interest rates similar to those of long-term Treasury bonds, but without any risk of loss of principal. Payment of principal and interest is guaranteed by the government, and the G Fund doesn't have any credit or default risk.

The TSP is not alone, Surz said. He also touts the comparative safety of the Office and Professional Employees International Union target-date fund, which holds 70% in stable-value assets at the target date, and the SMART Target Date Fund Index, which holds 70% in T-bills and intermediate TIPS.

“The 2020 funds of these safe TDFs have lost less than 5% this year, in contrast to the 15% loss of typical TDFs. Similarly, the 2010 funds of the safe group lost less than 5% in 2008, versus losses in excess of 30% in the risky group,” said Surz. “The safe group has and will protect. The risky group has and will not.”

Surz said he has been sounding the alarm for years that TDF beneficiaries are in greater retirement peril than they think. He believe his warnings have gained traction of late, however.

Morningstar, for example, recently released a report, “Way Too Much Risk in 401k Target-Date Fund Glide Paths,” which says, “It is clear that there is too much homogeneity in off-the-shelf glide paths that employers use given the heterogeneity of their workers’ needs.”

Surz blames lobbyists from the major TDF providers for derailing the increased safety measures recommended at the 2009 hearings, most notably a mandate to include the ending equity allocation in the fund name.  He is hoping his current push creates more concrete progress.

“We recommend that the DOL appoint a task force to create rules for a simple classification into ‘safe’ or ‘risky’ at the target date, and require disclosure of this classification in TDF fund names,” Surz said, adding that he is willing to serve on a TDF commission if asked.

“Most retirement savers are unaware of the threat they face during the five to 10 years before and after retirement," Surz warned. "But the next market correction will wake the sleeping baby boomer giant and slap it silly.”