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:
- There is no fiduciary upside to taking risk at the target date; only downside. The next 2008 will bring class action lawsuits.
- 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.
- 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.
- 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.
- 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
- SMART Fund Target Date Index Fund (Full disclosure, I sub-advise this fund)
- Putnam
- Wells Fargo
- John Hancock Choice
- PIMCO
- Allianz
- 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.
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:
- Fees: obtained from Morningstar
- # 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.
- 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 2nd 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 1st table is totally verifiable. We can discuss the weighting scheme in the following 2nd 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 |