“Everything should be made as simple as possible, but no simpler” – Albert Einstein
At $3.5 trillion and growing, target date funds (TDFs) are about half of 401(k) assets. They are very important. Yet there is not a standard benchmark for evaluating TDFs.
Fiduciaries are obligated to monitor the performance of their TDFs, and to select an appropriate benchmark. Many articles have been written about benchmarking TDFs. See for example my 2018 article that describes the many TDF indexes that are available.
In theory, fiduciaries should align the objectives of their TDF with those of the benchmark and confirm that the benchmark glide path and underlying allocations are in line with the TDF that is being evaluated. In practice, this is very hard to do, so I try in this article to follow Einstein’s advice to simplify.
What matters when, why and how?
The first step toward simplification is focusing on what matters. The list is short for TDFs. Retirement researchers report that only two things matter a lot: (1) savings and (2) protecting those savings in the transition from working life to retirement, called the Risk Zone.
Investment performance doesn’t matter much until we reach the Risk Zone. Until then savings are the most important contributor to wealth. Also, TDF glidepaths are very similar prior to the Risk Zone, so their returns are uniform at their longer dates.
The first simplification is to focus exclusively on performance at the target date, as was the case in the 2009 joint hearings of the SEC and Department of Labor on TDFs.
A distinction that makes a difference
One of the benchmarking complications is the distinction between “To” and “Through” but this is a distinction without a difference. A more meaningful distinction is Safe versus Risky at the target date, as shown in the following graph.
My humble recommendation
I recommend just two benchmarks, and using them to focus exclusively on performance in the Risk Zone. The S&P TDF Index is my Risky choice. It is a composite of most target date funds. As shown in the exhibit at right, most TDFs are more than 85% risky at the target date.
My recommendation for a Safe benchmark is the SMART TDF Index that tracks my patented Safe Landing Glide Path that is less than 30% risky at the target date. It’s followed by Soteria Personalized Target Date Accounts shown in the exhibit.
The results so far
TDFs for 401(k) plans came into vogue with the Pension Protection Act of 2006, so their history is short. For the most part, the Safe benchmark has underperformed because it has protected during a mostly rising stock market.
In the 15.5 years shown in the exhibit, only 2.75 years had losses in stocks. On an annualized basis, the Risky index has earned 3.6% per year while the Safe index trailed with a 2.5% return.
You could say that the cost to protect over this period has been about 1% per year (2.5% versus 3.6%). It’s similar to buying insurance. You hope you don’t need it, but you’re grateful when it protects you. Most of the history so far has not needed insurance, but that will change. It always does.
Surveys of participants report that they want protection near retirement in their TDF. Many even believe that they are guaranteed against loss. Fiduciaries want to be protected too—against lawsuits. The best fiduciary protection is participant protection.
Thus, the question reduces to what is a reasonable opportunity cost for protecting participants. Some level should be alright since that’s what it takes to give participants what they want. Or put another way, not protecting breaches the Duty of Care.
Implications for fiduciaries
The Government Accountability Office (GAO) is expected to release its TDF report this year. I’ve recommended that regulators require classification of TDFs as Safe or Risky. Fiduciaries would then make an explicit decision about risk because it would be in the fund name, and this would lead to the choice of benchmark.
Relative to Einstein’s guidance, it couldn’t be much simpler.
SEE ALSO:
• Who Suffers the Most in an Investment Market Crash?
• Target Date Funds are Not Protecting Those Near Retirement
Ron Surz is CEO of Target Date Solutions (TDS), co-host of the Baby Boomer Investing Show (BBIS), and author of the book "Baby Boomer Investing in the Perilous Decade of the 2020s." TDS licenses target-date fund usage of Ron’s patented Safe Landing Glide Path® (SLGP) that actually protects beneficiaries as they approach retirement. Individual investors can follow the SLGP at Age Sage, an educational interactive website. The BBIS educates baby boomers on the risks and rewards in contemporary investing, and Ron’s book is a tour of these shows. He can be reached at Ron@TargetDateSolutions.com.
