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TDFs invest in a mix of assets and aim to reduce equity exposure as participants approach retirement. The basic idea is good, considering that many investor portfolios suffer from benign neglect when it comes to rebalancing, fund selection and reducing exposure to riskier investments as retirement approaches.
But many retirement investors don’t really understand how TDFs are allocated between equities and fixed income. Fees can be high, and some critics don’t think TDFs are structured to select the best-in-class funds for all asset groups.
If you’ve defaulted into a TDF, check under the hood for these common problems:
Misunderstandings about risk: TDFs have come under fire for maintaining high equity allocations even in funds tailored for investors near retirement age. Many TDF investors near retirement age suffered dramatic losses in the 2008 market crash. Target funds with dates between 2000 and 2010 lost 22.5 percent in 2008, and funds with target dates between 2011 and 2015 lost 28 percent, according to Morningstar. But those are broad averages; some funds with dates as early as 2010 lost as much as 50 percent of their value in 2008.
The big 2008 losses can be discounted — to an extent — by the once-in-a-lifetime nature (one hopes) of the financial crash; the resulting liquidity crisis forced many fund managers to sell whatever they could to meet redemptions, resulting in especially large losses even in well balanced TDFs. But that doesn’t change the fact that there’s no industry standard for fund naming, or the perception gap among near-retirement investors who think they’ve adopted a more conservative posture.
The industry notes — correctly — that the glide path for most TDFs isn’t the target year of retirement, but some point beyond. “More TDFs are designed to deliver investment strategies for life — not just for your working life,” says a spokesman for the Investment Company Institute (ICI). “Few, if any, serious financial planners would recommend a 100 percent cash (or cash-and-bond) portfolio for a 65-year-old facing the potential of 30-plus years in retirement.
Fair enough — but that only points to the challenges of education and expectation-setting created by the way these funds are named. Disclosure and transparency also need to be improved; here’s what Morningstar had to say on the subject in its most recent annual survey of TDFs:
There are several major areas in which significant philosophical and pragmatic differences exist among the target-date series. These areas, outlined over the next five pages, are critical in fully comprehending the potential risks and performance behavior of a given target-date series and how that series compares with others in the target-date universe. Yet the disclosure and transparency on these subjects is in most instances inadequate. Even for Morningstar, it can be a struggle to get consistent information on basic glide-path allocations, never mind more sophisticated data.
Reforms have been proposed both by the Department of Labor and Securities and Exchange Commission aimed at addressing concerns about TDF naming, marketing and disclosure; the industry has endorsed some of the proposed changes.
High fees: Critics charge that fees often are too high due to the “fund of funds” construction of TDFs. Many TDFs charge fees for the underlying funds plus an overlay TDF management fee. The industry disputes this criticism; ICI notes that the asset-weighted average expense ratio for TDFs was 0.66 percent of assets as of May 2009, compared with 0.84 percent at year-end 2008 for comparable stock funds, and 0.63 percent for bond funds.
But a report from Brightscope, which measures and analyzes 401(k) fund performance, argues that asset weighting masks the true costs of most TDFs. Brightscope research indicates that the only two target date fund series with expense ratios below 0.66 percent are those of Vanguard, with a rock-bottom 0.19 percent and USAA (0.64). “The rest of the funds have fees over 0.66 percent,” Brightscope reports, “and over 50 percent of series have fees that are one percent or higher.”
“The more data you look at, you see that target date funds are a clever way to ratchet up fees in comparison with just selecting three or four individual funds,” says Mike Alfred, Brightscope’s CEO.
Home cooking: TDFs usually are assembled from in-house, proprietary underlying funds run by the record-keeping companies hired by plan sponsors. The problem: no one company will have best-in-class funds in every asset class. “One company might excel at large cap funds,” says Adam Bold, CEO of The Mutual Fund Store, a fee-only investment advisory. “But when you blend the return of all the proprietary funds in the TDF and layer on fees, it dilutes the performance down to mediocre or worse.”
If you’re in a TDF with high fees and sub-par performance, ask yourself whether it might make sense to turn off the cruise control by picking individual funds and rebalancing from time to time. Here’s what you’d need to do:
1. Set the right equity/income mix. You’ll need to decide what mix is best for now, and how much you’ll reduce equity exposure over time as retirement approaches. If you don’t have the training or experience to do so, use an advisory service like Smart401k.com.
2. Evaluate and select from available funds. For equity funds, pick the funds offering broadest market coverage with the lowest expense ratio. Advises Bold: “A fully diversified allocation should include at least one fund from each of the following asset classes: large growth, large value, small growth, small value, international, and bonds if appropriate.”
3. Ask your plan sponsor if any advisory services are provided. A growing number of plan sponsors are adding these services at no charge through their record-keeping firms. Advisers can help with fund selection and equity/fixed income balance.
4. Rebalance twice a year. It’s important to keep the equity and income parts of your portfolio split in roughly the same proportions you originally built into your plan. That means that you have to regularly rejigger your holdings so they stay in that balance.
Schwab has never been a major player in administering 401(k) plans for employers. The market is dominated by companies like Fidelity Investments, Vanguard and Aon Hewitt. But Schwab is preparing to roll out a new platform for 401(k) plans that it hopes will help it to crack the code.
The idea is to slash investment costs through exclusive use of passive investment vehicles – index funds and Exchange-Traded Funds (ETFs). Then, Schwab intends to plow some of the savings into investment advice for workplace retirement savers that would be built into the platform.
“In the old days of defined benefit pension plans, the outcome was managed for you by professionals,” says Jim McCool, executive vice president of institutional services at Schwab. “But in 401(k) plans, only about one out of 10 investors is getting professional help with investment decisions. We want nine out of 10 to get the benefit of a managed outcome, and take significant expense out at the same time.”
“Our conviction is that the two most incontrovertible features this industry needs to get its hands around are certainty of expense and the impact of advice,” he adds. “Putting those two together is a powerful combination.”
It’s not at all clear that Schwab can make a dent in the business, considering its lack of a track record in the 401(k) market. “Schwab was late to game, and they’ve had very little success cracking large company plans,” says Mike Alfred, CEO of Brightscope, which tracks 401(k) plan performance. “They have nothing to lose by trying this. Companies like Fidelity have a cash cow to protect with their 401(k) record-keeping businesses, and actively managed funds.”
Schwab intends to roll out the new platform in two phases. The first, targeted for launch in the first quarter next year, will be an offering of indexed mutual funds combined with managed accounts; later in the year, Schwab intends to launch a second offering combining advice with ETFs.
Schwab hasn’t released any details thus far on the fund choices to be included, except to say they will be a short list of ultra-low cost passive vehicles, with all major asset classes represented. Schwab also hasn’t named an investment advisory partner yet, although some news accounts have mentioned two companies already focused on advisory services for 401(k) participants – Financial Engines and Guided Choice.
What McCool does say is that Schwab’s 401(k) offering will cost investors no more than 60 basis points on managed assets, “all in.” That would be significantly lower than average.
Brightscope data shows that average 401(k) total plan cost can range from as little as 0.20 percent of assets for the largest plans up to a whopping five percent for smaller plans. And a key driver of cost is proprietary actively-managed funds on the platforms of the big 401(k) platform providers.
Expense is a key determinant of results. A Morningstar study released last year found that fees trumped even the investment firm’s vaunted star rating system as a predictor of success; low-cost funds reviewed by Morningstar had much better returns than high cost funds across every asset class from 2005 through March 2010.
Morningstar found that domestic equity funds with the lowest cost in 2005 returned an annualized 3.35 percent over the time period studied, compared with 2.02 percent for the most expensive group. Likewise, a 2006 report to Congress by the U.S. Government Accountability Office (GAO) found that a one-percentage point increase in fees reduced return over a 20-year period on a typical portfolio by 17 percent.
Schwab’s focus on advisory services is as significant as its intent to slash plan expenses. There isn’t much doubt that 401(k) investors need help. And a changing regulatory scene also could open up some new opportunities in the 401(k) landscape. The U.S. Department of Labor is preparing to adopt new rules that will make it difficult for 401(k) platform providers to sidestep fiduciary responsibility for their offerings – a legal definition that requires an advisor to put the best interest of a client ahead of all else.
That is setting the stage for more big platform companies to add Registered Investment Advisors (RIAs) –who are fiduciaries – to their teams in order to protect marketshare.
For example, Reuters reported recently that Merrill Lynch plans to make at least some of its brokers fiduciaries:
Merrill’s shift reflects the likelihood that the U.S. Department of Labor will adopt a proposal making it harder for advisers to escape assuming a fiduciary standard. If that occurs, advisers fear losing accounts to independent advisers willing to assume the higher standard of care.
“We are actively exploring ways to enter the 401(k) investment consulting market as fiduciaries,” said Andrew Sieg, head of retirement services for Merrill Lynch. He declined to elaborate.
The industry appears to be worried that small RIA firms will team up with open architecture 401(k) platform providers, such as Lincoln Trust and Aspire Financial Services to create cost-effective plans guided by RIAs. It could also include Schwab, which says it intends to market its new 401(k) platform through its existing advisor network.
That could be especially interesting for smaller plans, which often are saddled with higher-cost, lower-performing plans.
The industry insists that they are and banking regulators aren’t calling in the National Guard, although the U.S. Treasury Department is considering some emergency measures in case of a U.S. debt default.
Yet with the U.S. default risk hissing like a cobra, Congress and the White House at loggerheads and all the bad debt sloshing around Europe, is there a reason to be concerned?
Fear has reared its coiled head again. On Monday, stocks worldwide slumped on fears that Europe’s financial woes would spread to Italy.
If Congress doesn’t raise the federal debt ceiling, the prospects that interest rates will soar and there will be a run on money-market funds rise dramatically. Everything from company payrolls to Chinese stocks may get gobsmacked.
The government guarantees enacted in 2008 for money-market mutual funds are no longer in place. Money market accounts offered by banks with FDIC insurance are still covered.
Mutual funds are always subject to some credit risk, although it’s typically little since they only invest in relatively high quality short-term debt.
Although we’ve heard money-fund reassurances before, there’s no reason why there can’t be more transparency to see if investor concerns are justified. Remember that money funds had to be backstopped with short-term federal guarantees in 2008 when that market nearly crashed (along with nearly everything else except for U.S. Treasuries).
There’s also a lot of worry over whether sovereign debt from Greece and other troubled euro zone countries will hurt U.S. money fund portfolios. If you have a money fund that invests mostly in U.S. Treasuries, there’s no need to fret — unless the U.S. debt ceiling isn’t raised.
According to a statement issued by the Investment Company Institute on June 20, “U.S. money market funds have no direct exposure to Greek sovereign debt, and they have managed and continue to manage any indirect exposure.” The ICI is the Washington-based trade association for mutual funds.
What about European banks that hold Greek debt? They may be represented in U.S. money fund portfolios, hence the “indirect exposure” reference. Credit ratings agencies are reviewing those banks for any problems, which is always a concern. Check your fund prospectus to see what your manager holds.
While the ICI insists that “these are large, profitable banks and their exposure to Greek debt is a small fraction of their capital,” I’m not sure if anyone has fully explored the possibility of a Greek debt default on money markets. Will the European Central Bank step in to ensure liquidity? Probably. Will the U.S. Federal Reserve get involved? It would be obligated.
What’s fairly certain is that the 2008 meltdown has made mutual fund managers fairly careful in what they purchase for their portfolios, the vast majority of which never breach the $1 per share level.
“In general, money funds are being run more conservatively and with more portfolio holdings transparency than ever before,” emailed Mike Krasner, managing editor of the independent imoneynet.com website, which monitors the money fund industry. “For more than a year, U.S. prime (the highest rated) money-market funds have had no direct holdings of Greek debt, sovereign or private.”
Still, money funds can still “break the buck” if they take a big hit on bond defaults. How likely is that to happen? It depends on the money fund, its holdings, diversification and overall credit profile. Most money funds are probably safe, although there’s absolutely no government rule that says they have to return 100 percent of principal. It’s estimated that prime money funds hold about $1 trillion in debt from Euro zone banks. Most of that debt will likely be repaid, although the “black swan” event of a “run” on money funds holding euro debt is a worst-case scenario.
A recent history lesson is in order. The Reserve Fund, a money fund that had invested heavily in Lehman Brothers that failed in September, 2008, broke the buck. That triggered a run on all large money funds and forced the Fed to temporarily insure the holdings of those portfolios.
If you’re nervous — and can’t afford to lose any principal — there are always bank money-market accounts that carry FDIC insurance. You’re covered up to $250,000. The drawback is that they typically yield less than money market mutual funds. To find the highest-yielding account, see www.bankrate.com. Also check out your local credit union, which offers competitive yields.
The worst thing you can do is take the mattress strategy. A government-insured bank account is still safer than stuffing your cash under the pad you sleep on. You need that money to be secure and liquid to pay bills, taxes and cover emergencies. It’s better to have this money in a low-yielding insured account. You’ll lose much more sleep scrutinizing money-fund portfolios.
