“Target-date mutual funds are another Wall Street crime with the Department of Labor driving the getaway car.”
-Barry James Dyke, best-selling author and financial consultant.

Wall-street-corruptionTarget-date funds sound like a good idea, at least on the surface. Everyone knows that many Americans aren’t saving enough, and it seems that a “retirement for dummies” plan couldn’t hurt. The Department of Labor and 401(k) administrators concurred, and many plan sponsors decided to use TDFs as their plan’s qualified default investment alternative (QDIA) under DOL regulations.

But are target-date funds what they seem? Are they what they are advertised to be? Or has Wall Street taken us or a ride?

The DoL website correctly summarizes the supposed philosophy and goal of target-date funds:

“TDFs automatically rebalance to become more conservative as an employee gets closer to retirement.  The ‘target date’ refers to a target retirement date, and often is part of the name of the fund. For example… names like ‘Portfolio 2030,’ ‘Retirement Fund 2030,’ or ‘Target 2030’ designed for individuals who intend to retire during or near the year 2030.”

As another government website summarizes it,

Pick your retirement date, we’ll do the rest.”

“You don’t have to be an expert to figure out where to invest your retirement nest egg. Target date funds… automatically shift their asset allocations to become more conservative the closer you get to retirement.”

It sounds simple enough. So simple that one financial writer referred to target-date funds as “401(k) plans on autopilot.”

As we discussed in last week’s post, target-date funds have enjoyed tremendous popularity. However, the funds didn’t perform as advertised when the market crashed in 2008, and funds targeted for 2010 retirements plummeted an average of 23.5%. Nor have they turned in stellar performances most other years,  with many funds turning in losses even when the market has been flat or climbing.

Acting under pressure from Congress, the DoL and the SEC held their first joint hearing ever in June of 2009, to look into the “problem” of target date funds. The mutual fund industry’s message to the regulators could be distilled down to the following points:

  1. There is nothing wrong with the market or the management of these funds. Large losses are to be expected.
  2. As you can see from our fancy quantitative modeling based on past predictions, we need high equity allocations to offset “longevity” risk. (Translation: Never mind our previous rhetoric about investors needing a risk management that shifts over time from growth to preservation… we’ve realized that we can make more money by managing aggressively and managing funds ’til death, not retirement, so we’ve changed our strategy.)
  3. The real problems with these funds are the investors themselves. First, if they would just save more, we wouldn’t find it necessary to manage their retirement funds so aggressively, and secondly, they obviously don’t understand how target funds work if they are complaining about losses.
  4.  If you insist, we’d be willing to add some more fine print disclosures and a chart or two so nobody can say we didn’t warn them adequately about market risks and asset allocations.
  5. The “government” has no business regulating investments. (Never mind that our lobbyists worked so hard to get your cooperation in making these funds so popular!)
  6. Did we say our job was to manage funds “to” retirement dates”? We meant “through,” not “to” retirement! (Actually, we found it necessary to adjust our glide paths way beyond retirement dates to compete for short term gains, and to make up for those embarrassing 2008 losses…)

Now hip to the new target-date double-speak, the DoL website adds this subtle warning:

It is important to know whether a target date fund’s glide path uses a “to retirement” or a “through retirement” approach. A “to” approach reduces the TDF’s equity exposure over time to its most conservative point at the target date. A “through” approach reduces equity exposure through the target date so it does not reach its most conservative point until years later.

Target-date years are now rendered meaningless, and investors who didn’t want to manage their retirement funds in the first place are now tasked with reading the fine print to analyze and compare glide paths, asset allocations, and investment philosophies. Meanwhile, fund managers continue to raise the percentage of stocks (along with investor risk), extending the glide paths that represent the trajectory of change in asset allocation. (One company’s glide path does not reach its conservative endpoint until 30 years AFTER retirement. Let the absurdity of that sink in for a moment.)

The Department of Labor website continues its subtle “investor beware” rhetoric:

“Within this general framework, however, there are considerable differences among TDFs offered by different providers, even among TDFs with the same target date.  For example, TDFs may have different investment strategies, glide paths, and investment-related fees…. these differences can significantly affect the way a TDF performs….”

So, how different can two funds with the same target date be?

Enormously! Morningstar’s 2012 industry survey revealed that funds with a 2015 target date ranged from 20% to 78% in equities (the percentage of funds invested in the stock market.) Another survey showed funds 2010 target funds ranged from 0% to 64% in equity shares.

Despite pleas to the SEC to require certain standards and regulations in the naming of the funds (after all, a brokerage can’t simply call a fund “balanced” or “growth” or “international” without the fund containing minimum percentages of specific types of stocks), no rules have been passed to require funds with the same target date to resemble each other, or for funds to be managed consistently with the mandates implied by their target dates. (However, more fine print disclosures and charts have been mandated.)

And it’s not a simple matter of identifying “how much is in stocks and how much is in bonds.” One of the inconvenient truths of target-date funds that no one seems to be discussing is that they don’t merely subject investors to widely diversified stock market risk – it appears that some funds subject investors to other risks as well.

The funds have become more complex, featuring commodities, real estate, junk bonds (one John Hancock fund was outed for having 35% of a TDF in junk bonds), even derivatives. “It gives a false sense of safety,” said Robert Farrington of The College Investor website. “You never really know the exact contents, which makes overall portfolio diversification hard.”

In 2012, a year in which the S&P 500 and the Dow Jones both experienced healthy gains, four target-date fund brands posted double-digit losses. According to Morningstar’s 2013 industry survey, DWS TDF’s declined 10.37% (its fifth straight year of losses), Russell posted a negative 14.91%, Mainstay lost a quarter of their investor’s money (negative 25.2%) and Alliance-Bernstein posted losses of more than a third (negative 34.8%). (Outflows are net, after fees, which average just under 1%.)

Target-date funds were based on a philosophy that, if followed, would at least help to stabilize and ensure preservation of retirement funds for those who might have previously been entirely at the mercy of the stock market roller-coaster. But as Target-Date Analytics concluded, fund managers are guilty of “sacrificing prudent risk management for their investors as the target date approaches,” “performance chasing,” and “risk management abandonment.”

An observer might think that the real purpose of target-dated funds is to market existing funds in a new package to expand market share. Instead of preserving capital as funds mature (which used to be the assumed aim), some fund managers are managing for performance, not safety, as target dates draw near. Competing for short-term gains, fund managers sacrifice stability and ignore responsibility to guard retirement funds against loss.

Like gambling in Vegas on someone else’s dime, apparently it’s easier to take risks when it’s not your own retirement fund. And unfortunately, with effective lobbying strategies in place, nobody seems willing to hold Wall Street accountable for its gambling habit. Fund managers can call the funds whatever they like, regardless of glide path, and they can put whatever they want in those funds, as long as they disclose it to the potential investors. (You know, the ones looking for the simple set-it-and-forget it option.)

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