white paper Challenges to Target Funds James Breen, President, Horizon Fiduciary Services

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1 Challenges to Target Funds James Breen, President, Horizon Fiduciary Services Since their invention in the early 1990 s Target Date Funds have become a very popular investment vehicle, particularly with 401(k) Plan Sponsors and Plan Participants who are seeking a simple and effective one stop solution to the problem of investing for retirement. Today there are over 1600 Target Date Funds with aggregate assets well into the hundreds of billions. Certainly the idea of a Target Fund has great merit; one simply establishes their desired retirement date, places their assets in the fund which most closely corresponds to that date and goes about their normal business without worry. Many studies have shown that Plan Sponsors and Participants are poorly equipped to make good investment decisions. Target Date Funds, with their professionally managed approach to asset allocation, security selection and adjustment through time, can alleviate the problem of poor decision making for many individuals and Target Date s simplicity can make life easier for scores more. For all of their virtues however, there are several severe and pressing issues within the Target Fund area which need to be addressed if Target Funds are to live up to their promise as effective retirement savings and post retirement income management vehicles. While recent proposed regulation attempts to address some of these issues, it is our view that the potential problems in the Target Fund space are ultimately beyond the reach of financial regulation and are more centered around their structural limitations and the investment theory shortcomings at play in the current Target Fund environment. In our view there are five key areas which need to be addressed in order to improve the Target Investment Approach to an acceptable level of effectiveness. 1. Asset Allocation: To or Through? 2. Optimization Strategy: Mean-Variance or Success Probability 3. Sequence of Return Risk 4. Fee Structure, Conflict of Interest Avoidance 5. Fiduciary Oversight Asset Allocation: To or Through? The Target Fund approach to asset allocation works by investing aggressively in equities during the early years in an effort to drive higher returns and gradually lowering the equity exposure in favor of lower risk fixed income investments as the retirement target draws closer. The process by which this risk transition takes place is typically referred to as the glidepath. Embodied within the construction of the glidepath exists an important philosophical assumption that can have enormous implications for investors. If the objective of the Target Fund is to produce a relatively certain level of assets at the retirement date, the glidepath must provide for an almost risk free investment strategy as that date draws near. To most effectively carry out this strategy, equity exposure would be entirely eliminated and fixed income would be invested with low duration and high credit quality. If however, the objective of the Target Fund is to provide an appropriate long term investment strategy to be carried out by investors beyond their retirement date, the glidepath towards risk reduction would be much less steep because the typical time horizon for an investor at their retirement age can be 20 years or longer; certainly a long enough investment horizon to take advantage of riskier assets. 1

2 This philosophical conundrum is known as the To or Through question. Is it the mission of the fund to deposit investors at a known point when they retire or to serve the interest of investors who have potentially already retired? Those who argue for the To Approach correctly point out that many 401(k) Participants roll their money out of their 401(k) Plan when they leave the company, and as such, are no longer invested in the Target Strategy. These investors may be best served by increasing the certainty of their asset level at retirement to most effectively plan for their future needs. Those who argue for the Through Approach point to the fact that many investors remain in their 401(k) Plan after they leave their company (as well as those investors who may come into Target Strategies on their own, not part of a 401(k) plan). These investors are best served by a strategy which explicitly considers their needs through retirement. A less steep approach to glidepath construction allows for higher return generation in many investment environments during the time leading up to, at, and just past retirement; however it opens the possibility of sharp, short term downturns. While there is no one right answer to the To or Through question, recent history shows that there can be severe consequences to placing investors with disparate To or Through needs into the same commingled investment pool. Looking at the average asset allocation of Target Date Funds, it would appear that the Through Approach is the predominant philosophical underpinning to the determination of the glidepath. The average equity exposure in this category is 45%, with the remaining 55% in fixed income (source Morningstar). Further, the average duration within the fixed income component is 4.6 years, and the average credit quality split is 65% AAA and 35% AA or below. On average 10% of the bonds have a credit rating of BBB or below. Undoubtedly the combination of equity exposure and interest/credit risk made for a very difficult year in 2008 when the average Target Fund fell by -22.2%. For investors who were planning to retire and roll their assets from their Target Funds at precisely the wrong time, this downturn obviously had a very unfortunate impact. Unless these investors changed their plans and remained in their Target Fund or were able to quickly deploy into another investment vehicle with like asset allocation after their roll over, they were unable to take advantage of the 2009 rebound. This sort of whipsaw loss is exactly the sort of poor decision making that Target Funds were supposed to protect investors from. For 401(k) Fiduciaries, particularly those who utilize Target Funds as Qualified Default Investment Alternatives, it is of paramount importance that the To or Through component of the Target Funds offered to Participants be well understood. While Plan Fiduciaries fall under a Safe Harbor in their provision of Target Date Funds as QDIA s, they are still responsible for the prudent monitoring and selection of the Target Funds which are utilized. Ideally the Plan s framework should be robust enough to accommodate disparate To or Through needs. Optimization Strategy: Mean-Variance or Success Probability Another, perhaps more subtle, but extremely important component of the asset allocation methodology in Target Funds is the way they define success for their investors. In constructing the asset allocation structure and glidepath it is typical for the Target Fund Manager to utilize optimization techniques to help insure that the chosen glidepath represents the best possible opportunity to produce successful outcomes for investors. The way in which optimization is utilized can have a large impact upon the glidepath, which in turn has a large impact upon investors. One very common optimization approach is to set an annual rate of return objective for a 3-5 year time horizon and utilize the long term average returns, risk (variance) and correlations of the major asset classes to find the asset allocation which historically, on average, provided the rate of return objective while taking, on average, the least amount of risk. Typically the rate of return objective would be set at 5-7% above inflation in the early years of a Target Fund and be gradually reduced over time to reflect the increasing importance of current income and lower tolerance for short term fluctuation in the later years. This Mean-Variance optimization approach is one of the cornerstones of modern portfolio theory and has been widely utilized by institutional investors for many years in the management of defined benefit pensions. 2

3 While the idea of having returns be as high as possible and having risk be as low as possible has great intuitive appeal, the Mean-Variance optimization approach may not be the best way of creating good solutions for individuals because of the limitations inherent in utilizing the Variance measure as the definition of risk for individuals. Unlike a defined benefit pension which has an indefinite lifespan, an individual has a finite time horizon with an absolute endpoint. Given this structure and the utility preference of most people that it s better to have extra money left at the end of their life than to run out early, Variance is an improper measure of risk. This is because Variance measures outcomes which are both above and below the average. In effect, a financial planning /investment process which defines a required return objective and sets the asset allocation with Mean/Variance Optimization is tantamount to saying that it s ok to have a 50/50 chance of not reaching your goals. For most individuals, this would not be acceptable if it were put to them this way. A more robust approach to optimizing the asset allocation of a Target Portfolio would be to determine the asset allocation which would produce the lowest incidence of failure (i.e., running out of money early) for a typical individual within the Target Pool. Ideally this might be specifically addressed at the individual Participant level. This approach would very likely lead to a more aggressive glidepath structure in the early years and a more dynamic adjustment process of income management and risk taking in the later years. To make this sort of evaluation successfully for individual investors in Target Funds may require more customization than mutual fund vehicles like Target Funds can provide. As with the To or Through question, it s possible that one size simply won t fit all. Sequence of Return Risk When considering the possible outcomes in providing an investment strategy designed to last for years one quickly realizes just how daunting a task this can be. Clearly the time horizon is long enough to mandate that short term risk be taken in order to drive sufficient long term return, and average returns over a time horizon this long have historically borne out the wisdom of risk taking. That said, the long term average result is the aggregation of shorter periods. Some of those short periods are inevitably nasty to investors. The placement in the sequence of very negative short term periods can have an enormous impact upon the success of a strategy. If the very early years are hit hard by negative results, even if there is significant rebound in the later years, the damage to the retirement of the Participant may have already been done. A Participant in this type of sequence of returns may appear successful because they do not outlive their assets, however they may have been much more constrained in their retirement than their long term average result might suggest. Conversely, if there is a very large shock to the portfolio (beyond the normal glidepath s ability to buffer risk) near the end of the strategy, this could prove catastrophic to Participants who spent more freely in the early years of retirement on the strength of their early success only to face an unpleasant surprise in their later years. While there is no magic bullet to eliminate the sequence of return risk in target portfolios, the typical asset allocation glidepaths do not address protection against tail risk or catastrophic risk. As with risk modeling structures that focus on Participant probability of success, the integration of risk modeling which is focused specifically on providing mitigation from the most negative market environments may be a very valuable addition to a target portfolio approach. Fee Structure/ Conflict of Interest Avoidance In recent years there has been increased scrutiny placed on Plan Fiduciaries to make certain that they ve avoided incurring excessive fees to the Plan and have prevented conflicts of interest amongst the vendors to the Plan. While Target Date Funds do not necessarily cause problems in either of these areas, their structure should be carefully scrutinized by Plan Fiduciaries. 3

4 Usually Target Date Funds are structured as Funds of Funds, built by their providers from other funds within their organization (often with all of the fees imbedded within the underlying funds being utilized). For example, the Vanguard Target 2020 Fund, one of the largest Target Funds as measured by assets under management, is comprised of the Vanguard Total Stock Index, the Vanguard Total Bond Index, the Vanguard European Stock Index, the Vanguard Pacific Stock Index, and the Vanguard Emerging Markets Stock Index. While an allocation approach like this with level fees paid to each component, like (passive) investment philosophy across components and overall fees below the category average, is unlikely to cause any problems, other Target Funds routinely make investments to internal vehicles which have non level fee structures, differential capacity constraints, and varying levels of success if evaluated relative to best in class active management due diligence/scoring. This could leave door open to both excessive fees and conflicts of interest on the part of the Target Fund Provider. Because the Plan Fiduciary has no control over the underlying portfolio decisions within the Target Funds being utilized, and the Target Fund organization has no Fiduciary Responsibility to the Plan, it is clear that the need for vigorous scrutiny by Plan Fiduciaries should not be understated. Fiduciary Oversight One of the most critical misunderstood and evolving areas in the management of Retirement Plans is the provision of fiduciary oversight. Who is a fiduciary? Who isn t a fiduciary? When is there a safe harbor? At the time of this writing, one thing is clear; the providers of Target Date Funds are not fiduciaries. In a December, 2009 Advisory Opinion, the Department of Labor ruled that there is nothing in ERISA which would cause the providers of Target Funds to be considered Plan Fiduciaries. The gist of the logic is that mutual funds don t know anything about the individuals who have invested with them, and therefore cannot be held to a standard which requires them to act in the best interest of people that they know nothing about. Further, since Target Date Funds fall within the category of Fund of Funds, which existed at the time of ERISA s passage in 1974, and Congress offered no special provision for Fund of Funds, the DOL has argued that none was intended by the law. This should give Plan Sponsors and their advisors who are considered fiduciaries pause. In 401(k) Plans which utilize Target Funds, particularly those where Target Funds are specified as QDIA s, the entity which drives asset allocation, arguably the most important determinant of performance, has no fiduciary responsibility to those for whom they are making this critical decision. Summary Target Date Funds have provided many investors, particularly 401(k) Participants with a one stop solution to the complex problem of investing effectively for retirement. In this sense, Target Funds have been a very valuable addition to the investment landscape. We believe however, that the Target Fund approach might be greatly improved by more flexible and explicit treatment of the To or Through Issue for Retirement Plan Participants, more Participant specific modeling of risk in determining the appropriate asset allocation glidepath, greater fee transparency and process validation in the selection of underlying investments and the adoption of fiduciary responsibility by the providers of this important service. Target Funds as they are today represent an important first step in improving the investment decision making for those who are seeking to do their best to retire well. We believe that the time is right for Plan Sponsors and Investors to take the next step in forcing the evolution of discretionary retirement advice. The needed tools to enhance risk management, create more sophisticated asset allocation, insure fee efficiency and the delivery of enhanced fiduciary oversight all exist today. With these enhancements a Target Date approach to the provision of retirement investments, already a good idea, can become a great idea. 4

5 DISCLOSURE The information herein is believed to be reliable and has been obtained from sources believed to be reliable, but Horizon Investments, LLC ( Horizon ) makes no representation or warranty, express or implied, with respect to the fairness, correctness, accuracy, reasonableness or completeness of such information. This presentation is provided for information purposes only. This presentation and the materials contained herein (this Presentation ) should not be construed as an offer to sell or the solicitation of an offer to buy any security. Horizon is not soliciting any action based on this Presentation. Any offering or potential transaction that may be related to the subject matter of this communication will be made pursuant to separate and distinct documentation and in such case the information contained herein will be superseded in its entirety by such documentation in final form. It is being provided for the general information of the specific, intended recipient. This Presentation does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of clients of potential clients. This presentation is designed to give the specific financial professional to whom it is presented, a general conceptual description of a product that Horizon has created. This presentation and any other communications or information (the Information ) provided by Horizon with respect hereto is intended solely for the intended recipient and under no circumstances may a copy of the Presentation or Information be shown, copied to, transmitted or otherwise given to any person other than the intended recipient. Advice, if any, given in this Presentation is not intended to be advice concerning tax matters and cannot be relied upon. 5

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