Last week, Professor of Finance at Griffith Business School at Griffith University, Michael E. Drew*, was the only academic invited to present at the Securities and Exchange Commission and the Department of Labor Joint-Hearing on target date funds. He writes exclusively for conexust1f.flywheelstaging.com on his submission, which questions the conventional use of age-based approaches to asset allocation, and the implications for pension funds.
The Securities and Exchange Commission (SEC) and the Department of Labor (DOL) are to be congratulated for holding their Joint-Hearing regarding target date funds and other similar investment options on June 18. Target date funds (TDFs) are investment products that allocate aggressively during the early years of their existence, moving to a more conservative asset allocation as the’target date’ approaches.
The performance of 2010 target date fund cohort, ranging from around -3 per cent to in excess of -40 per cent in 2008, was the catalyst for regulators to start to look under the hood of this increasingly popular investment methodology. Could you imagine the horror of receiving your end-of-year statement in early 2009 with your 2010
target date fund balanced down -40 per cent!
So what has driven this outcome? The funds that performed best in 2008 had, as expected, around 90 per cent in bonds versus the worst performers with only one-third of their fund in bonds. This incredible range of return outcomes strikes at the heart of the target date fund debate. Testimony heard at the Hearings confirmed the wide-ranging views on the design of the glide path. More troubling was the lack of consensus on whether target date funds are best designed “to” the target date (that is, when the investor retires and stops contributing to the funds) or “through” the
target date. Proponents of the “through” strategy argue that higher allocations to equities are prudent to assist with
the management of longevity and inflation risk in retirement. Proponents of the “to” strategy argue passionately that that, in the case of a 2010 target date fund, the fund would be de-risked (say, nor more than 10 per cent in equities) as at 2010.
Now is the time to return to that old chestnut, ‘truth-in-labeling’. It is clear that there are at least two clusters in the target date fund universe: ‘ retirement TDFs’ – those funds who de-risk to an accumulate balance at the target date;
and, ‘lifetime TDFs’ – those funds design to continue the glide path for, say, two decades post the target date.
It goes without saying that the global financial crisis has provided TDFs the ultimate stress test. The results of the stress test suggest that many investors, as well as plan sponsors, simply did not understand the competing approaches to the target date. The economic reality is that, for those investors in 2010 target date funds, it is probable that these losses may never be recovered, particularly if the capital within the fund is the primary source of retirement income.
A further issue that will continue to come under the increased scrutiny of regulators is the apparent conflict of interest of mutual fund complexes ‘feeding’ their own in target date structures. It was reported at the Hearing that over
two-thirds of all TDFs invest in their own family of funds. It seems very difficult to imagine a world where an active fund manager would be best-in-class across all asset classes. In addition to the labeling issue, greater fee transparency is required as a matter of urgency.
The central theme of my testimony to the Hearing related to the efficacy of the age-based glide path itself. Recent work with my colleague, Dr Anup Baus (Queensland University of Technology) published in the current edition of the Journal of Portfolio Management (Spring, 2009), suggests that the key issue facing target date funds is when to expose the largest amount of money to growth asset classes.
The research finds that ‘autopilot’ investing, where asset allocation decisions made simply on the basis of age, may provide only limited downside protection for investors, while materially capping the upside.
The testimony called into question the conventional use of age-based or ‘deterministic’ approaches to asset allocation
decision and called for consideration to be given to more dynamic approaches to the problem.
Dynamic target date funds would, at the heart of their design, include a feedback loop that keeps risk on the table when a fund is below its accumulation target and potentially de-risk when ahead of the retirement savings goal. These ideas are considered in a paper again with Basu and Dr Alistair Bryne from the Edinburgh Business School entitled “Dynamic Lifecycle Strategies for Target Date Retirement Funds” (see SSRN:http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1302586)
So what does all this mean for large pension funds?
There is no doubt that the notion of glide-path investing is an elegant one. It’s conceptual simplicity is attractive to plan sponsors and investors alike. However, as the wide range of views expressed at the Hearing suggests, the glide path is a deceptively complex problem. It is key for fiduciaries to have a clear stance on issues such as “to-verus-through” design; the disclosure of fees and the efficacy of the glide path itself.
We await the actions from the Hearing with much anticipation. There is clear confusion and misunderstanding in the TDF universe, not just on the part of investors, but by mutual funds and fiduciaries that requires immediate attention.
*Michael Drew was the only academic invited to testify at the Hearing and his testimony is available at www.sec.gov.
The views expressed in this article are his and do not necessarily reflect the views of the QSuper Board of Trustees. michael.drew@griffith.edu.au
