An In-depth Report on Target Date Fund Glide Paths: Introducing Prudence Scores

Asset allocation is the primary determinant of investment performance and risk. Many say asset allocation explains more than 90% of investment results, but the fact is that it explains more than 100%.  Because of this importance, we provide a detailed examination of target date fund glide paths in order to differentiate the good from the bad. Our focus is on fiduciary responsibility and the characteristics of a glide path that make it prudent. Prudent glide paths are good. Imprudent glide paths are not good for both beneficiaries and fiduciaries. A glide path does not have to produce high returns to be prudent. In fact, high returns can be an indication of imprudent risk taking.

Defining prudence

The benefits of target date funds are diversification and risk control, both at a reasonable price. All three of these benefits vary widely across target date fund providers. Diversification is important at long terms to target date. We see consensus in high equity allocation, so the differentiator is diversification, i.e. combining different types of equities.

Theory states, and evidence confirms, that diversification improves the risk-reward profile of a portfolio. Greater diversification leads to higher returns per unit of risk, and is a benefit of TDFs. Near the target date we see wide disagreement, with equity allocations at target date ranging from a high of 70% to a low of 20%.

The prudent choice is safety at the target date, the other benefit of TDFs. In other words the diversification benefit is best seen at long dates, and the risk control benefit is most manifest at the target date. These two key benefits, plus fees, are discussed in the following in the order of their importance.

The most important benefit is safety at the target date

Safety at the target date is the most important benefit for the following reasons:

1. There is no fiduciary upside to taking risk at the target date; only downside. The next 2008 will bring class action lawsuits.
2. There is a “risk zone” spanning the five years preceding and following retirement during which lifestyles are at stake. Account balances are at their highest and a participant’s ability to work longer and/or save more is limited. You only get to do this once; no do-overs.
3. Most participants withdraw their accounts at the target date, so “target death” (i.e., “through”) funds are absurd, and built for profit. All TDFs are de facto “to” funds.
4. Save and protect. The best individual course of action is to save enough and avoid capital losses. Employers should educate employees about the importance of saving, and report on saving adequacy.
5. Prior to the Pension Protection Act of 2006, default investments were cash. Has the Act changed the risk appetite of those nearing retirement? Surveys say no.

I’ve used the PIMCO Glide Path Analyzer to measure TDF risk near the target date. Risk is measured in two ways: maximum 12-month loss (also known as drawdown), and standard deviation. Only a handful of TDFs provide true safety at the target date. They are, in order of lowest risk first:

Best risk control

1. SMART Fund Target Date Index Fund (Full disclosure, I sub-advise this fund)
2. Putnam
3. Wells Fargo
4. John Hancock Choice
5. PIMCO
6. Allianz
7. USAA

The second most important benefit is reasonable cost

Fees undermine investment performance and are the basis for several successful lawsuits. You can be the judge of what is reasonable, keeping in mind that you want to get what you pay for. The challenge for plan providers is achieving good diversification for a reasonable cost. Assets that diversify, like commodities and real estate, are expensive.As shown in the following table, only a handful of TDFs are low cost, similar to the scarcity of TDFs that provide safety at the target date. You need to ask yourself what you get for a high fee that you can’t get for a much lower fee.

5 lowest fees

1	Fidelity Index	16
2	Vanguard	17
3	TIAA-CREF	21
4	SMART Index – Hand B&T	34
5	Wells Fargo	53

Source: Morningstar

Diversification is the third most important benefit

Using the PIMCO “Glide Path Analyzer,” five firms stand out as having the broadest diversification at long dates.

Best diversification

SMART Index – Hand B&T

Allianz

JP Morgan

PIMCO

Voya

Principal

Putting it all together: Prudence scores

To summarize, some TDFs provide good safety, while others provide broad diversification, and still others provide low fees. To integrate these three benefits we’ve created a composite prudence score. Details are shown in the Appendix. The following table (click to view) shows these scores and compares them to Morningstar ratings. High Morningstar ratings go to funds with a high concentration in US stocks because US stocks have performed very well in the past 5 years. High Performance is not the same as Prudence. In fact, it’s currently an indication of imprudent risk concentrated in US stocks.

Prudence Scores vs. Morningstar Ratings (click to view)

Source: Target Date Solutions

The tendency is for the eight highest prudence scores to get low Morningstar ratings. Prudence scores below the top eight tend to get Morningstar ratings above 3.5 stars. The difference, of course, is performance, especially recent performance that has benefitted from high US equity exposures. This “Group of 8” deserves your attention.

Conclusion

Fiduciaries now have a choice between TDF rating systems that are quite different. You can choose between prudence and performance. The cost of prudence in rising markets is sacrificed performance, but this sacrifice pays off in declining markets and can easily compensate for sacrifices. We hope you find this glide path report and prudence score helpful. We also hope that plan fiduciaries will vet their TDF selection. The fact that more than 60% of TDF assets are with the Big 3 bundled service providers suggests that fiduciaries are not considering alternative TDFs, so participants might not be getting the best; they’re simply getting the biggest.

**Full disclosure: Surz sub-advises (manages) the SMART Target Date Fund Index that is included in this report.

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Endnote Many thanks to PIMCO for letting me use their Glide Path Analyzer. It’s great. That said, the views expressed in this report are strictly my own. Appendix: Constructing Prudence Scores The Prudence Score is not very quantitative, & much simpler than Morningstar ratings. It uses only 3 pieces of information:

1. Fees: obtained from Morningstar
2. # of diversifying risky assets at long dates: I counted these, & excluded allocations that are less than 1%. Some funds have meaningless allocations to commodities for example.
3. Safety at target date: % allocation to cash & other safe assets, like short term bonds & TIPS.

Here’s the table I filled out by hand:

Company	Fee (bps)	# Risky	% Safe
SMART Index – Hand B&T	34	6	90
Allianz	90	6	40
John Hancock Ret Choice	69	5	40
PIMCO	65	6	30
JP Morgan	82	6	30
Harbor	71	4	35
Blackrock Living Thru	98	5	35
Wells Fargo	53	5	25
Invesco	111	4	40
Putnam	105	3	40
MFS	102	6	25
Schwab	73	3	30
Guidestone	121	5	30
DWS	100	5	25
USAA	80	4	25
BMO	68	3	25
Franklin LifeSmart	110	5	25
TIAA-CREF	21	3	15
Vanguard	17	4	10
Hartford	117	5	25
Voya	113	6	20
Nationwide	89	6	15
American Century	96	4	20
Principal	86	6	10
Russell	92	5	15
Alliance Bernstein	101	4	20
Mass Mutual	97	5	15
T Rowe Price	79	4	15
Fidelity Index	16	3	5
Great West L1	99	4	15
Blackrock	98	5	10
John Hancock Ret Living	91	5	5
Great West L2	102	4	10
Manning & Napier	105	4	10
Fidelity	63	3	5
Mainstay	92	3	10
American Funds	93	3	10
Legg Mason	139	5	10
Franklin Templeton	110	4	8
Great West L3	95	4	5
State Farm	119	4	5

The next step is a little quantitative. I made up some rules for the importance of each factor:

• Safety got the highest importance. I adjusted the “% safe” allocations so the safest got a score of 25
• Fees are 2^nd in importance. I weighted them at 15.
• Diversification gets a max score of 10

Then I add the 3 scores for each & divide this sum by 10, so the highest composite score is 5: (25 + 15 +10)/10 The 1^st table is totally verifiable. We can discuss the weighting scheme in the following 2^nd table:

	Prudence Scores
Company	Fee (15)	Divers(10)	Protect(25)	Prudence	Mstar
SMART Index – Hand B&T	12.8	10	25.0	4.8	1.5
Allianz	6.0	10	25.0	4.1	1
John Hancock Ret Choice	8.5	7.5	25.0	4.1	2.9
PIMCO	9.0	10	18.8	3.8	4
JP Morgan	7.0	10	18.8	3.6	4
Harbor	8.3	5	21.9	3.5	3.4
Blackrock Living Thru	5.0	7.5	21.9	3.4	3.2
Wells Fargo	10.5	7.5	15.6	3.4	1
Invesco	3.4	5	25.0	3.3	4
Putnam	4.1	2.5	25.0	3.2	3.1
MFS	4.5	10	15.6	3.0	3.6
Schwab	8.1	2.5	18.8	2.9	3.6
Guidestone	2.2	7.5	18.8	2.8	3.3
DWS	4.8	7.5	15.6	2.8	3.3
USAA	7.2	5	15.6	2.8	3.5
BMO	8.7	2.5	15.6	2.7	4
Franklin LifeSmart	3.5	7.5	15.6	2.7	4
TIAA-CREF	14.4	2.5	9.4	2.6	3.5
Vanguard	14.9	5	6.3	2.6	3.5
Hartford	2.7	7.5	15.6	2.6	3.8
Voya	3.2	10	12.5	2.6	2.8
Nationwide	6.1	10	9.4	2.5	3.5
American Century	5.2	5	12.5	2.3	2.8
Principal	6.5	10	6.3	2.3	3.3
Russell	5.7	7.5	9.4	2.3	3.3
Alliance Bernstein	4.6	5	12.5	2.2	3.6
Mass Mutual	5.1	7.5	9.4	2.2	3.7
T Rowe Price	7.3	5	9.4	2.2	3.7
Fidelity Index	15.0	2.5	3.1	2.1	3.1
Great West L1	4.9	5	9.4	1.9	3.3
Blackrock	5.0	7.5	6.3	1.9	3.3
John Hancock Ret Living	5.9	7.5	3.1	1.6	3.2
Great West L2	4.5	5	6.3	1.6	3.4
Manning & Napier	4.1	5	6.25	1.5	4.2
Fidelity	9.3	2.5	3.1	1.5	3.3
Mainstay	5.7	2.5	6.3	1.4	3.6
American Funds	5.6	2.5	6.3	1.4	4.1
Legg Mason	0.0	7.5	6.3	1.4	3.3
Franklin Templeton	3.5	5	5.0	1.4	4
Great West L3	5.4	5	3.1	1.3	3.5
State Farm	2.4	5	3.1	1.1	3.2