A RETIREMENT DATE IS NOT A COMPLETE STRATEGY Target Date Funds are only Part of the Solution

A RETIREMENT DATE IS NOT A COMPLETE STRATEGY Target Date Funds are only Part of the Solution By Robert L. Padgette, CFA, CIMA and Ted Ponko, CFA, CEBS Retirement plan assets in target date funds increased 130% from 2005 to 2008 1 and seven of ten 401(k)s now offer them. 2 But target date funds including those with near term dates suffered major losses in 2008. Because the declines were so prevalent, discussions about target date funds (TDFs) raged in the media, culminating in a June 2009 DOL/SEC joint hearing on the topic. In spite of the controversy, their popularity continues, but participants still struggle to understand and use them wisely. 3 And why not? Plan Participants are given precious little guidance other than to look for the fund that matches their anticipated retirement date. The presumption is that is all they need to know. TDFs are often presented as a one decision investment; just set it and forget it. Compared to the daunting task of creating one s own mix from a long list of available funds, this is understandably the preferable option. The problem is, it is often not a good one. A SIMPLE SOLUTION Over the past decade, the United States has not been a nation of savers. The national savings rate fell from a high of 10 percent in 1982 to a just under 1 percent in 2008. It edged back up in 2009 4, but still remains well below that of other developed countries. Just when the Baby Boomers need to save more, they are saving less, despite the benefits of tax deferral and matches in their employer sponsored 401(k) plans. One of the major reasons eligible employees shy away from participating in their retirement plans is the lack of guidance. An April 2009 study by the Employee Benefit Research Institute (EBRI) found that, Just one quarter of workers (24 percent) are very confident that they are investing their retirement savings wisely (down from 45 percent in 1998). Another 54 percent are somewhat confident that their savings are wisely invested. 5 Just under half had attempted to calculate how much they needed to save for retirement and roughly the same number simply guess what they ll need. 6 Target date funds are often presented as a simple way to attack all these issues with the hope of enhancing (and perhaps even increasing) employee savings and participation. The concept is simple: Rather than discouraging participation by requiring the employee to determine specific retirement needs and investments, he just selects the fund with the target date closest to his expected retirement date. Rather than worrying about picking the right investments, monitoring, and rebalancing them, the participant simply leaves those decisions to the fund s professional money manager. When the participant is young, the manager will invest more aggressively, while there is more time to make up any short term losses. As the participant nears retirement (or even in the years immediately thereafter), the manager will pare back the risky equity exposure and increase the safer fixed income elements. This so called glide path distinguishes between funds with different target dates, and matches the level of risk and return to the participant s current age. From the participant s standpoint, it s done automatically making the TDF a one decision plan. There s no need to answer hundreds of questions or make assumptions about future investment returns and inflation rates as required by many of today s calculators and guidance tools. Not only are plan sponsors, their advisors, and participants attracted by TDFs ease, the Department of Labor gave them an additional boost by granting them Safe Harbor under ERISA 404(c)(5) when used as the retirement plan s Qualified Default Investment Alternative (QDIA): In defining qualified default investment alternatives, the Department presumes that, in those instances when a participant or beneficiary chooses not to direct the investment of the assets in 1 of 7

their account, the only objective and readily available information relevant to making an investment decision on behalf of the participant is age. For this reason, the investment objectives of the qualified default investment alternatives are not required to take into account other factors, such as risk tolerances, other investment assets, etc. 7 So it s no wonder TDFs have enjoyed explosive growth. Employees have one less obstacle to participating in their retirement plans, advisors have an easy to understand recommendation for every one of them, and plan sponsors are afforded a safe harbor protection through their use. Presumably, everyone comes out ahead as long as they overlook some major shortcomings. NOT A SIMPLE PROBLEM The glide path is a TDF s primary distinguishing feature. Unlike other mutual funds that are managed according to style mandates or to preserve a specific level of risk, TDFs are combinations of equity and fixed income holdings the manager will adjust to reflect the investor s anticipated changing risk tolerance. The fund s glide path usually reflects a declining level of risky equity exposure over time. By assessing the glide path, it s possible to get a sense of the TDF s risk at future times. However, glide paths can vary substantially even for TDFs with the same target date. This is problematic for 401(k) participants who are encouraged to select plan investments based solely on their anticipated retirement date. (A chart illustrating the equity glide paths of unique fund groups appears in the Appendix.) Chart 1 SELECTED EQUITY GLIDE PATHS Consider the five groups illustrated on Chart 1. Equity exposure is measured on the vertical axis and retirement date is shown on the horizontal. The latter has been put in reverse chronological order to better illustrate the glide paths over times. The Old Mutual Conservative funds (yellow diamonds) have one of the least risky glide paths while the Alliance Bernstein Retirement Strategy funds (blue diamonds) have one of the highest. The Data Source: Morningstar Principia, July 31, 2009 other three fund groups tend to bunch together, yet significant differences can be found there as well. For example, a 40 year old planning to retire in 25 years would generally be directed to a 2035 fund. If his plan used the Fidelity Freedom Funds, a little over 81 percent of his balance would be invested in equities. However, if his plan offered the comparable T. Rowe Price Retirement or Vanguard Target funds, he d have seven percent more equity exposure. In fact, with either of the latter two, in five years he would still have about 85 percent in equities. Arguably, if this investor really needed an allocation with 81 percent equities, he would be best served with the Fidelity Freedom 2035 Fund, the T. Rowe Price Retirement 2025 Fund, or the Vanguard Target 2030 Fund, hardly a result you would anticipate based solely on his expected retirement date. The participant has no way to make this assessment, so the allocation he gets will simply be a function of the glide path of the particular fund family used in the plan. This isn t to say there is one correct glide path for all funds. For example, Old Mutual, one of the groups illustrated in Chart 1 offers three sets of TDFs, Conservative, Moderate, and Balanced. The risk levels at each step along the glide path are commensurate with the fund s names. As this suggests, investors, even of the same 2 of 7

age, have differing needs, propensities, and assets. They may also need differing glide paths in their TDFs, but simply choosing based on their ages will lead them all to the same allocation. Ironically, because most 401(k)s don t include TDFs from more than one family of funds, 8 the choice of a participant s glide path is determined more by the plan sponsor s choice of fund family than by the participant s specific needs and goals. Complicating matters further is the fact that a TDF s reported equity allocation is not a complete analysis of its glide path s risk exposure. Returns can differ dramatically depending on the fund s allocation among styles, capitalizations, and foreign holdings. 9 In addition, some TDFs use leverage or are funds of funds making the actual holdings and risk breakdown even more difficult to determine. Participants certainly can t analyze this, so they must rely on the choices made by their plan s sponsor or advisor. Even if a 401(k) s fiduciaries make a diligent effort to select an appropriate array of TDFs, a deeper, more fundamental problem remains: Participants of the same age have differing resources, goals, and preferences. Their retirement objectives and current savings can vary widely. Some may be well on the way with a considerable sum already stashed away while continuing to contribute at a high level. Others may just be starting to save with limited ability to contribute. For some, it is important to retire at age 62 while others may want to work as long as possible. In fact, two participants of the same age may want to retire at the same time with the identical amount of retirement income, but if they place different priorities on of each of these goals, their preferred savings and investment strategies will differ. TDFs address everyone s retirement strategy only in terms of risk and return, but the decision is and should be multi dimensional. Not only do a number of factors come into play, the importance of each also differs from one participant to another. In essence, TDFs are a one size fits all solution when everyone really wears a different size. They enable all participants to get a simple answer, yet the answer rarely, if ever, truly fits any specific participant. Most importantly, even if the risk and return profile of the chosen TDF suits the participant well, he still has no idea if it will enable him to meet his retirement goals. The investment allocation over time is only part of one s overall retirement strategy. Without setting a definitive goal, the participant will never be able to gauge progress towards it. TDFs alone are not a complete answer. TDFs AS PART OF THE SOLUTION A number of calculators have been developed to meet these needs. Typically, they enable the participant to personalize the results by entering his existing retirement balance, current savings rate, and investment mix. Additional questions regarding attitudes toward risk and return or desired retirement age help generate potential solutions. The participant can usually supply all variables except one (e.g. retirement age or income), and the tool will either provide a likely result (e.g. Your annual retirement income will be $30,000 ) or probability (e.g. You have an 80% probability of achieving your goal of $30,000 annual retirement income. ) If the participant isn t happy with the results, he can change inputs to find a more acceptable solution. More and more plans are using TDFs as investment options. The calculators help set goals, the TDFs provide the investment management. This is certainly a step in the right direction. In a 2008 survey, the EBRI found that 44 percent of participants who actually used a retirement savings calculator reported changing their strategy with 59 percent changing their savings rate or investment mix. 10 The problem is, most calculators don t really evaluate the recommended TDF. They simply make an assignment according to the participant s age or at most, the TDF s current asset allocation. In other words, after the participant goes to the trouble of personalizing the inputs, most calculators recommend the same TDF he could have initially chosen just based on his expected retirement date. The TDFs are not 3 of 7

analyzed according to the participant s goals and needs, and his priorities are rarely if ever considered. In essence, the typical guidance calculators are just another way of assigning TDFs with the one size fits all approach. THE COMPLETE SOLUTION A well crafted retirement savings strategy is based on a number of different factors. In addition to the investment decision, desired retirement age, income replacement percentage, savings rate, and deferral type (e.g., pre tax or Roth) must also be considered. Each individual will place a different importance on each factor, so his ideal solution will be unique. Rather than a simple choice of an investment portfolio based on a retirement date assumption, this is a multi dimensional decision which will involve trade offs between the different factors (Save more now or brace for potential losses associated with more aggressive investments? Plan to work longer or expect less income in retirement?) The participant will find greater utility (satisfaction) in those strategies that come closest to not only meeting his goals, but also meeting the goals he feels most important. Chart 2 SUCCESS and SATISFACTION All Strategies with a Minimum 75% Chance of Success The tradeoffs, priorities, and satisfaction level are important factors to consider when the end game is consistent savings and staying the course. Some combinations may be more appealing while others may have higher probabilities of success. Potential strategies for one participant are illustrated by the blue diamonds in Chart 2. 11 Each is a combination of the participant s acceptable range and priorities for retirement age, retirement income, savings rate, and investment risk. Only those with at least a 75 percent chance of success are illustrated although there are hundreds more with lesser likelihood. In this case, the yellow diamond represents the participant s best alternative. It has the highest satisfaction score 12 with more than the minimum required probability of success. As described above, traditional retirement planning calculators give participants the opportunity to calculate potential outcomes based on combinations of participant supplied inputs. Given enough time, persistence, and iterations, it is conceivable they could use a traditional calculator to arrive at the solution with their highest satisfaction and probability of success it is just not very likely. It is even less likely if participants cannot evaluate the risk and return profile of the available investment options. This is precisely what happens when calculators do not truly evaluate the TDF options. As noted earlier, TDFs composition can vary considerably even for funds with the same target date. Oddly enough, the differences can actually be greater as participants near retirement. 13 This critical information must be included in the overall assessment of potential strategies, and can only be accomplished if the funds themselves are analyzed based not only on their current composition, but on their future glide paths as well. An effective analysis must consider the funds asset allocation at the asset class level (e.g., style, capitalization, bond 4 of 7

quality, etc.) as well as the use of leverage. In effect, TDFs should be evaluated in the same detail as traditional funds even if the plan s TDFs come from only one fund family. Fortunately, software is available to assist in bringing all these elements together to arrive at each participant s optimal strategy. We used Klein Decisions K 4 Plan Goals to run the simulations illustrated in Chart 2. Only a few participant inputs are required: The acceptable ranges of retirement age, retirement income, acceptable loss in a poor year, and the importance he places on each. K 4 Plan Goals then combines these with an asset class analysis of potential portfolios (including TDFs) to run thousands of Monte Carlo simulations on the various combinations. The probability of success and the participant s satisfaction are calculated for each alternative. Unlike traditional calculators, the results are not hit or miss because all combinations are evaluated and ranked. As you can see from Chart 2, strategies falling along the red line are those with the highest satisfaction for differing probabilities of success, forming the efficient frontier of retirement strategies. The strategy with at least the minimum acceptable probability of success and the highest satisfaction score (the yellow diamond on Chart 2) is recommended to the participant. 14 No additional iterations are needed; they have all already been checked. This is the participant s own, unique strategy for success. According to the 2008 EBRI survey, One tool that appears to be particularly effective in changing behavior is the retirement savings calculation. 15 Fifty six percent of those surveyed preferred a tool that provided a solution tailored to their particular situation, while only thirty one percent favored answers that are more generic. 16 Without the benefit of a complete solution from a solver like K 4 Plan Goals, TDFs are at best generic answers. They can, however be a vital part of the more tailored strategy once the solver determines which specific fund is best suited to the participant. Although it may not be the one with the name corresponding to the participant s anticipated retirement age, it will provide professional management and be much easier to implement than selections from a list of funds. Not only that, its selection will be based on the participant s goals and priorities rather than the sponsor s choice of fund family. Participants are more likely to act if their alternatives are simple and easy to understand. In concept, TDFs are certainly simple, but not so easily understandable. Given their varying glide paths and associated levels of risk, simply matching the TDF with the participant s anticipated retirement date is actually an oversimplification. With a little additional effort from the participant, a real solver like K 4 Plan Goals, can provide the complete, unique solution. Correctly analyzed TDFs can then be a simple investment selection based on the participant s retirement goals and priorities, not just his expected retirement date. TDFs can be part of a simple solution, but not all of it. 5 of 7

APPENDIX EQUITY GLIDE PATHS Unique Funds, July 31, 2009 Data Source: Morningstar The chart above illustrates the equity glide paths of the 49 unique target date fund groups from 45 different fund families. When possible, A shares were used. Values represent equity allocations with no adjustments for leverage or derivatives. 6 of 7

1 2009 ICI Investment Company Fact Book 2 Target Date Funds: Plan and Participant Adoption, by the Vanguard Center for Retirement Research. 3 According to Ibbotson Associates Target Maturity Report Second Quarter 2009, Survey based data highlighted that many investors do not understand the risks associated with target date funds, with some investors thinking that traditional target date funds offer some form of guarantee or minimum. Additional disclosure may help, but the benefit will be limited if participants don t take the time to research it. 4 The U.S. Department of Commerce s Bureau of Economic Analysis, press release BEA 09 34, dated 8:30 a.m. August 4, 2009. 5 Employee Benefit Research Institute Issue Brief, No. 328, April 2009, p. 19. 6 Ibid., pp. 21 22. Unfortunately, the EBRI also found, the amounts that workers think they need to accumulate for a comfortable retirement continue to appear to be rather low. Twenty eight percent of workers say they need to save less than $250,000, and another 19 percent mention a goal of $250,000 $499,999. 7 Default Investment Alternatives Under Participant Directed Individual Account Plans; Proposed Rule, Federal Register, Vol. 71, No 187, Wednesday, September 27, 2006, p. 56810. 8 Virtually all plans utilizing TDFs use the entire group offered from just one fund family. This is a logical choice to coordinate the funds across all age groups and eliminate potential overlaps or significant differences within glide paths. It is, however, a move away from the last decade s push to an open architecture offering of best in class funds each drawn from a broad universe of fund managers. 9 Preliminary research across unique shares of TDFs suggest there is a direct correlation between up equity market return and total stock allocation, but a negative correlation between mid cap allocation and down equity market return. This was certainly true for the three TDF families in the foregoing example. Insufficient data was available to analyze the effects of leverage, but none of the funds in the example used leverage during the measurement period. 10 Employee Benefit Research Institute Issue Brief, No. 316, April 2008, p. 19. 11 The data for this chart was generated using Klein Decisions K 4 Plan Goals software using a limited data set for illustration purposes. 12 The satisfaction score is actually the combined utility function given the participant s goals and priorities. 13 For example, in the July 31, 2009 Morningstar data, equity exposure for unique 2030 TDFs ranged from 65% to 87% while standard deviation went from 20.4 12.3%. For unique 2040 TDFs, the respective rangers were 93 72%, and 19.9 14.2%. 14 Satisfaction dominates probability of success because of the trade offs inherent in the strategy. In order to increase the chance of reaching his retirement goals, the participant must be willing to save now, work longer, take more investment risk, or a combination of these factors. These sacrifices at least partially offset the added utility of meeting the retirement goals leading to a lower satisfaction score for the overall strategy. 15 Employee Benefit Research Institute, No. 316, op. cit., p. 19. 16 Ibid. 7 of 7