TDFs say they follow academic lifetime investment theory, but they are much riskier at the target date than this theory. Plus, the evidence of investor preference is voice-of-client surveys of participants who report that they want to be safe near retirement.
I am the lone crusader for minimizing the risk in target date funds (TDFs) as they approach retirement. Although TDF risk is lower for those near retirement than for younger people, I say that it’s not low enough, and that it’s almost the same for both young and old if you consider bonds to be risky, as we observed in 2022.
Risk is rewarded until it’s not. I suspect my concerns will garner support in the aftermath of the next stock market crash, but it will be too late then. It will take lawsuits to recover losses then, as opposed to guarding against them now, before the crash. Color me frustrated. And color participants shocked.
Glidepath designers trade off the desire to grow assets against the need to protect them. You can’t do both. In the 1970s TV sitcom “All in the Family,” Edith Bunker explains, “I don’t want my money to work. I want it to relax.” Money actually is “relaxed” at the target date in the academic theory that establishes glidepaths but TDF designers do not use the theory they say they use.
The theory invests 80% risk-free (relaxed, not working) in the transition from working life into retirement, while TDF practice is less than 15% risk-free and more than 85% risky—a huge difference.
Edith is right to disagree with common wisdom; after all, “relaxed” investment near retirement is the cornerstone of academic lifetime investment theory. Participants are not getting the protection that theory prescribes so they are much less protected than they should be near retirement.
Also, surveys report that participants want to be protected, and they think they are. That’s the evidence that participants want safety at the target date. Participant best interests are not being served. The next stock market crash will shock them, just as participants were shocked in 2008, and this time will be worse than 2008.
Both theory and evidence argue for more safety at the target date than most TDFs currently provide. If this topic interests you, I direct you to my favorite article, Target Date Fund Elucidations, a comprehensive review. Here are a few of the highlights from that article, in the hope that they will inspire you to read the whole piece.
The retirement crisis is shocking
70% of baby boomers have saved less than $300,000. But an SEC report entitled “Perspectives on Retirement Readiness” says the solution is not to increase investment risk. Rather, the solution is modifying behavior by encouraging beneficiaries to save more.
Savings plans have evolved to encourage savings in a number of ways including:
- Auto enrollment
- Auto escalation
- Education
- Contribution matches
“Save and Protect” should be the mantra of retirement savers. Getting people to save early and save a lot is the first objective. Then protecting those savings as retirement nears is the next step in alleviating the crisis going forward.
Unfortunately, not much can be done investment-wise for current retirees who have under saved, but our society supports the less fortunate elderly.
In the debate between low and high risk, high risk is winning in popularity, for now.
The TDF bifurcation: Safe or risky
TDFs are differentiated by the shape of their glidepath and the risk at the target date. There are three different glidepath shapes:
- “To” glidepaths end at the target date. Because they end, their glidepath is flat in retirement
- “Through” funds serve beyond the target date, to death. Their glidepaths typically flatten out beyond the target date.
- “U” funds are both “To” and “Through.” They are exceptionally low risk at the target date, and then re-risk in retirement.
The common belief is that “To” funds are less risky at the target date than “Through” funds but there are many exceptions to this belief. A more straightforward approach is to differentiate between Safe and Risky at the target date.
Not all TDFs suffered losses greater than 30% in 2008. A few are designed to be very safe at the target date with less than 30% in risky assets including:
- The Federal Thrift Savings Plan (TSP), the largest savings plan in the world
- The National Retirement Savings Plan of the Office and Professional Employees International Union (OPEIU), one of the largest AFL-CIO unions
- The SMART Target Date Fund Index, A normative index for safe TDFs
TSP and SMART lost only 10% in 2008. OPEIU launched in 2019.
There is huge disagreement between these two groups due to differences in objectives. The Risky group believes high risk is necessary because people have not saved enough and they’re living longer. Their stated objectives are to replace pay and manage longevity risk, but these are mere hopes. Risk cannot make up for inadequate savings. Saving enough is the only way to achieve the Risky group’s objectives.
By contrast, the Safe group aims to protect in the well-documented “Risk Zone” spanning the 5-10 years before and after retirement. Retirement researchers have documented “Sequence of Return Risk” (SORR) where losses in the Risk Zone can irreversibly spoil the rest of life. The Risky group doesn’t acknowledge this risk.
The other explanation for the two groups is profits. Investment management firms are in the business of investing other people’s money for profit, the more profit the better. Accordingly, their design of a TDF maximizes profits within the rules of TDFs. The only such rule is that the glidepath should reduce risk through time, but the amount of reduction is unspecified.
Most fund providers have used the target date opportunity to package up product, allocating to their own proprietary funds. They charge a management fee to hire themselves. Also, recent research shows that proprietary equity funds have underperformed.
The greatest profit is made at the target date because that’s when account balances are at their highest. Combining the rules with the profit motive leads to a design with the highest equity allocation allowed at the target date. That highest acceptable allocation is about 60% based on the ubiquitous 60/40 rule and the actual TDFs designed by investment management companies.
The other consideration is how the remainder is invested, basically the amounts in long-term bonds and safe assets like stable value. Since fees on long-term bonds are higher than those on safe assets, the majority of the balance (the 40%) is in long-term bonds.
By contrast, the Safe group of TDFs is designed by financial engineers for the benefit of participants. Financial engineers are trained to design investment risk and reward tailored to investor specifications. Experts in retirement savings and investments like Dr Wade Pfau and Professor Moshe Milevski say that it is important to not lose participant savings, especially as participants transition from working life to retirement.
This transition period is called the Risk Zone. Financial engineers use a discipline called “liability-driven investing” (LDI) to guard against losses along the glidepath, and to protect in the Risk Zone with very safe investments—much safer than the designs created by investment firms. A financially engineered glidepath ends at the target date with 30% in equities and long-term bonds, and the balance in safe assets like T-bills, intermediate term TIPS, and stable value.
The good news about 2008 is that not much was at stake, with $200 billion in TDFs, which was less than 10% of 401(k) assets. The next 2008 will be devastating by contrast, and it’s not a matter of if—it’s a matter of when.
Conclusion: Will TDFs change?
TDFs did not change following the 2008 crisis. In fact, they became riskier. So why would they change now? Because there’s much more at stake, as shown in the following. Also, we’ve hopefully become smarter.
This time, unlike 2008, there could be lawsuits for excessive risk that ignores SORR, a very well-documented threat to retirement with dignity. Excessive risk lawsuits could be even more effective than excessive fee lawsuits because the harm could be enormous.
A repeat of 2008 will drain $300 billion away from participants in 2020 funds alone. Even if lawsuits don’t happen, employers will be pressured to compensate for the losses.
The fiduciary Duty of Care is like our responsibility to our young children. Defaulted participants should be protected from avoidable harm.
Stay tuned.