A Better Option Than Target-Date Funds

In the 20 years since they first hit the market, they’ve become the fastest-growing products in the defined contribution market. The total amount of assets parked in TDFs reached $690 billion as of June 30—6% higher than a year ago, according to Morningstar. Total investor inflows into TDFs neared $15 billion in the second quarter, marking a 25% increase over their historical quarterly-average inflow of $12 billion.

Despite their massive success, TDFs are horrible options for most people for myriad reasons.

On the surface, TDFs appear to be custom-tailored retirement products; however, they are a one-size-fits-all product. TDFs assume that everyone retiring the same year will have the same risk tolerance and investment objectives. They automatically increase bonds and reduce equity allocations as they approach their target year. The rationale is to decrease the portfolio’s volatility and preserve capital as people near retirement. But the strategy fails to consider that a person’s portfolio will likely be much bigger toward the end of his career than in his early years. Growth in a portfolio’s size greatly influences how it should be positioned.

“By mechanistically switching to conservative assets in the later years of a plan, lifecycle strategies sacrifice significant growth opportunity and prove counterproductive to the participant’s wealth accumulation objective,” Anup Basu and Michael Drew wrote in “The Journal of Portfolio Management” in 2009. “This sacrifice does not seem to be compensated adequately in terms of reducing the risk of potentially adverse outcomes.”

There is no industry standard for the ideal portfolio allocation for any given retirement year. They all have different asset mixes, risk profiles and fee structures, making them very difficult to evaluate. Portfolios for the same target years have wide disparities in equity and bond exposure depending on the fund family.  Equity allocations in 2015 TDFs range anywhere from 13% of portfolio assets (John Hancock Funds Retirement Choices at 2015 Portfolio) to 54% (Great-West Secure Foundation Lifetime 2015 Fund).

2050 TDFs have as little as 21% of assets in stocks (Invesco Balanced-Risk Retire 2050) to 91% (Schwab Target 2050). Someone who plans to retire in 36 years should accept more risk than just 21% exposure to stocks. Likewise, people retiring next year may want to reduce significantly their equity stakes in case the stock market free falls into a 2008-like bear market. On the other hand, retirees who plan to work part-time or those with cash saved up outside of their retirement accounts may want more exposure to stocks. TDFs have no way of assessing an individual’s situation.

TDFs follow preset investing mandates to put a set amount of portfolio assets into bonds and stocks. They mostly run on autopilot based on historical performance without regard to market conditions. They fail to consider expected future returns. Bonds offered great returns since 1981 as interest rates fell from an epic peak. But the next few years may be the worst time in history to be heavily invested in bonds if interest rates rise. The Federal Reserve has kept interest rates near zero since 2008 to stimulate the economy. It’s expected to lift rates in early to mid-2015. If interest rates rise significantly higher just to normalize, bond prices will fall, erasing the paltry yield income plus some.

The more exposure TDFs have to long-dated bonds, the more sensitive they will be to interest rate fluctuations. iShares 7-10 Year Treasury Bond (IEF) tumbled 6.1% last year, when 10-year Treasury yields added 1.18 percentage points, ending the year at 3.04%. In contrast, Vanguard Extended Duration Treasury ETF (EDV), a fund of 20- and 30-year government bonds, crashed 19.9% in 2013, while yields on 30-year Treasuries climbed only 0.92 percentage points to 3.96%.

The 10-year Treasury yield, currently 2.40% as of August 19, can climb more than two percentage points just to return to its historic average of 4.63%. If a one percentage point increase in yields translates to high single-digit loss in principle, a two-percentage-point rise in yields will surely be painful. If the U.S. follows in Japan’s footsteps and experiences nearly two decades of near-zero policy interest rates, 2% yields in low-risk, short-dated bonds will hardly keep up with inflation.

At the same time, stocks are equally risky in the current market environment. Breadth indicators show the S&P 500 is extremely overbought, Brad Lamensdorf of the “Lamensdorf Market Timing Report” wrote in the August issue. The stock market is trading at its second-highest valuation in last 60 years. The current S&P price-to-sales ratio is near its dot-com bubble high of 1.77. The non-financial market capitalization-to-gross domestic product ratio is presently more than double a pre-bubble historical average of about 0.55 and approaching a high of 1.54 from 2000, says John Hussman of Hussman Funds.

“At present, the most historically reliable valuation measures are more than 100% above pre-bubble historical norms,” Hussman wrote in a commentary titled “Yes, This Is An Equity Bubble” in late July. “The extent of this bubble is also partially obscured by record-high profit margins that make price-to-earnings ratios on single-year measures seem less extreme (though the forward-operating P/E of the S&P 500 is already beyond its 2007 peak even without accounting for margins).”

Investors can reduce investment risks by diversifying into alternative-asset classes with a lower correlation to stocks and bonds such as commodities, real estate, private equity and hedge funds—asset classes to which most TDFs do not allocate assets. Yale University’s David Swensen, chief investment officer of the country’s second-largest endowment, has long championed investing in alternatives in the endowment model. Their allocation to alternatives is mostly to illiquid funds as they are trying to capture the illiquidity premium. However, given the proliferation of alternative strategies in 1940 Act funds, investors can now invest in liquid endowment portfolios that can produce a superior risk-adjusted return similar to what was available to university endowments.

“This diversification benefit of alternative assets reduces the volatility of the fund’s market value, enabling endowments to better implement long-term projects and making future contributions of the plan sponsors more predictable,” Abdullah Sheikh and Jianxiong Sun wrote in “The Journal of Alternative Investments” in Spring 2012.  An endowment-styled three-dimensional asset allocation which incorporates alternative investments is now accessible to investors in a fully liquid portfolio, says Tim Landolt, Managing Director of ETF Model Solutions, LLC.

Retirement plan sponsors, consultants and advisers should consider the changing market conditions and wide variation in the asset allocations used by TDFs before incorporating them as investment options within plans.

 

Prateek Mehrotra, MBA, CFA, CAIA, has more than 20 years of experience with alternative investment strategies for institutional and individual investors.  He serves as the chief investment officer of Endowment Wealth Management and ETF Model Solutions in Appleton, Wisconsin. The firms have recently launched the Endowment Index and the Endowment Collective Fund for 401(k) plans as an investment option that provides a hedge against equity market declines as well as higher inflation.  

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author(s) do not necessarily reflect the stance of Asset International or its affiliates.