Confidence in Target Date Funds is a Mistake Waiting to Happen

According to a recent Voya survey, 71% of employed target date fund (TDF) investors feel confident about reaching their retirement goals, compared with just 58% of non-investors.

TDFs are confidence builders because participants are told that they are smart and safe. And it doesn’t hurt that they have in fact been smart and safe following the crash of 2008.

But what will happen to TDF participants when the next crash happens? After all, the last stress test of TDFs was way back in 2008 when TDFs failed to protect. That will happen again. Opinions will change.

Challenging Stein’s Law

Confidence in TDFs hasn’t been challenged for a long time. It’s been 17 very good years since the crash of 2008, so there really hasn’t been much risk, but there will be some day. Stein’s Law has not been rescinded: If something cannot go on forever, it will stop. And this time much more is at stake. In 2008, there was only $200 billion in TDFs, although that was enough to prompt the first and only joint hearings of the SEC and DOL. These hearings focused on people near retirement in TDFs. Baby Boomers were not near retirement in 2008. The 30% loss in 2008 was $60 Billion.

Now most Boomers are in their Retirement Risk Zone and there’s $4 trillion at stake. A 30% loss now would be $1.2 Trillion (with a T). The Retirement Risk Zone is the 5 years before and after retirement during which Sequence of Return Risk peaks, meaning that losses can devastate the rest of life.

Nothing changed after 2008, but the next time that the market crashes regulators and plaintiff attorneys need to read the theory behind TDF glidepaths. Theory did not come up in the joint SEC-DOL hearings, but it should have.

Academic theory applies to everyone because everyone has a lifepath in which paychecks culminate in the Retirement Risk Zone. This article speaks specifically to baby boomers because they are currently in the Risk Zone. Others will follow, as will more crashes.

The next crash and academic lifetime investment theory

Boomers in TDFs will be hardest hit in the next crash because TDFs do not defend against Sequence of Return Risk. I predict that Boomers will get revenge for losses in their TDFs . When the stock market crashes, Boomers will be mad that they were not nearly as protected as they think they are.

Most TDFs say they integrate Human and Financial Capital as shown in the following.

The theory makes a lot of sense. It provides a framework for our important risk decisions through time. Our money should work hard for us when we’re young, and then it should relax when we’re old. The big question is: How relaxed? The theory says: Very relaxed. TDF practice says: Not much.

Here is the application of the theory that has emerged from this framework. Please read these.

Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance, 4/1/2007, Roger G. Ibbotson, PhD, Moshe A. Milevsky, Peng Chen, CFA, and Kevin X. Zhu

Lifetime Financial Advice: A Personalized Optimal Multilevel Approach, 2/15/2024, Thomas M. Idzorek, CFA and Paul D. Kaplan, CFA

Bottom line, theory is very safe for people near retirement and common practice is not.

Some say that I have misinterpreted the theory. I disagree of course, but you can be the judge. Please read the theory and see what you think. One fund company acknowledges that it takes more risk than theory in its TDF because people do not save enough.

Saving enough is important, and so is not losing those savings. If you’re near retirement, you’re done saving, so protecting whatever you have saved is very important because that’s all there is.

The fact is that participants in TDFs think they are protected as they approach retirement, which is in line with theory but not practice, bringing up lots of questions, like:

• Why do participants think they are protected?
• Who told them they’re protected?
• Why do TDFs breed confidence?
• Why don’t fund companies follow the theory they say they follow?

The next crash will motivate answers to these questions as the damage is assessed.

Assessing the damage requires a different benchmark

Hopefully, the damage from the next crash won’t be too bad. Baby Boomers will be hardest hit so they will clamor for some sort of recovery, perhaps even in lawsuits.

The S&P and Morningstar TDF benchmarks are most popular. Both are consensus benchmarks that measure common practice. My TDF benchmark article describes these common practice indexes in detail and introduces my alternative index called SMART (Scientific Monitoring and Ranking Technologies). SMART Indexes are available on Morningstar Direct. Importantly, SMART indexes are normative—the way things should be—and follow academic theory.

You can’t assess the damage of the next crash by using a common practice benchmark because that index will also suffer the same damage. One lose—all lose is not OK when there is a safer path.

After the next crash, TDF providers will say the resulting loss is affordable because taking risk has made you rich. The question will be whether you’re rich enough to afford the loss, and whether anyone can “afford” a loss. The answer to that question requires an answer to another question—relative to what? The damage should be assessed relative to the theory that TDFs say they follow and that surveys say participants want. That’s the SMART choice.

The SMART 2010 Index has completed its lifetime journey and has succeeded. The other SMART Indexes are continuing their journey and currently lag the industry so far because they are safer. They will win in the next crash and form a basis for evaluating departure from theory.

Assigning blame

Fiduciaries choose TDFs on behalf of participants who default into a Qualified Default Investment Alternative (QDIA). At the June 2009 hearings on TDFs, fund companies denied accountability for losses, saying that participants should have known, but participants don’t understand or look. Participants trust their employers, who should know.

Fiduciaries—namely plan sponsors and their advisors—need to look beyond prospectuses to see the risk in TDFs as revealed in Prudence Scores. Academic theory is never used in prospectuses—a legal document—but it is commonly used in marketing material.

And fiduciaries need to understand the difference between procedural prudence and substantive prudence.   Common practice is procedurally prudent and believed to be best practice that is substantively prudent, but it is not best practice if there’s a better way. Eventually substantive prudence becomes procedural prudence, but that has not happened yet for TDFs.

Relying on procedural prudence currently gets you high risk near retirement. It’s risk that participants don’t know they’re taking, but they will know in the next crash because it will shake their confidence.

Getting Justice

I have no legal background, so I asked Grok AI if the next stock market crash might bring TDFs into court for the harm caused by not defending. Here’s Grok’s answer.

### Legal Basis for Lawsuits

Under ERISA, plan fiduciaries must act prudently, loyally, and in participants’ best interests. Suing for excessive risk tied to theoretical deviation could allege:

– **Breach of prudence**: Fiduciaries failed to select or monitor TDFs that align with advertised theories, exposing participants to undue risk. Better-aligned alternatives strengthen the case, (Author comment: Better-aligned alternatives include the SMART TDF Index, the $Trillion Federal Thrift Savings Plan (TSP), the $100 Billion flexPATHs, and Dimensional Fund Advisors’ TDFs. )

– **Misleading disclosures**: Prospectuses and marketing often invoke academic theory to imply safety, but if risks are understated, this could support claims of fiduciary misrepresentation. (Author comment: Prospectuses say nothing about theory, but marketing material does. A prospectus is a formal legal document that could be used in court. Marketing is promotion.)

– **Excessive risk as a scandal**: Experts predict this as the “next 401(k) scandal,” especially post-crash, when losses highlight the gap. So far, bull markets have masked issues (risk rewarded), but a downturn could trigger mass suits, similar to post-2008 litigation over TDF drawdowns of 30-40%.

While many suits focus on fees or performance, excessive risk has been a key thread and tying it explicitly to theoretical deviation could gain traction if plaintiffs prove fiduciaries ignored warnings (e.g., from academic benchmarks).

Conclusion

Nostalgia ain’t what it used to be. There are similarities between today’s Big 3 TDF providers and the Big 3 automobile companies of the 1960s. The muscle cars of the 1960s were fast and fun, but not safe. Such is the case with today’s TDFs.

Safer approaches will gain traction when TDFs crash in the next stock market correction. Risk has been winning for a long time, but that will end. Perhaps then risk will be disclosed in the fund name, as proposed at the 2009 hearings.