Several years ago, I developed a Prudence Score for target-date funds as an alternative to Morningstar and fi360 ratings that place a heavy emphasis on performance.
My thesis is that TDFs should defend near the target date because that is the prudent thing to do, so my Prudence Score places a heavy weight on protecting near the target date. I wrote about my Prudence Score in this 2015 article that featured a graph similar to this:
Last week I wrote about recent Congressional interest in TDF risk and decided to update my 2015 article. The interested Congressional members offer the Federal Thrift Savings Plan (TSP) L Fund as an example of a TDF that has protected those near retirement from investment losses. The L Fund is less than 30% in risky investments near the target date, in contrast to 90% for the typical TDF (55% equities plus 35% long-term bonds). With six million beneficiaries and $800 billion in assets, the TSP is the largest defined contribution plan in the world.
Regulatory interest
The new Congressional inquiry is concerned about risk near the target retirement date for beneficiaries who are near retirement. Similarly, the joint hearings of the SEC and DOL in June 2009 focused entirely on 2008 investment losses in 2010 funds for those retiring between 2005 and 2015. Could it be that Congress cares more about old people than young people? Or is there a recognition that investment losses do more harm to those near retirement? While Congress appears to have this greater jeopardy view, the TDF industry disagrees. This article explains why risk near the target date is so important. High risk near the target date has been rewarded over the past 12 years as the US stock market has soared more than 400%, but this current decade of the 2020s is likely to bring a market correction. It’s a decade when most of our 78 million baby boomers will be in the “Risk Zone” described in the following.
Why TDFs should be safe near the target retirement date
Retirement researchers define a “Risk Zone” spanning the 5-10 years before and after retirement. Losses in this zone can spoil the remainder of life, even if markets subsequently recover. In normal times, investors accept a “risk of loss”, but this becomes the “risk of ruin” in the Risk Zone because of “Sequence of Return Risk.” In the absence of cash flows, return sequence doesn’t matter because you can earn returns in any order and the cumulative return is unchanged. But withdrawals in retirement change the math big time. Losses early on hurt much more than losses later in life when account balances are lower. Beneficiaries near retirement probably won’t recover from the next market correction if they are in a typical TDF, but there are a few safe TDFs like the TSP.
The other reason to be safe near the target date is DOL guidance to choose a TDF based on the demographics of the workforce. This guidance should more appropriately be directed to the demographics of defaulted beneficiaries since most TDF assets are those of defaulted participants. These beneficiaries have only one demographic in common: they are all financially illiterate. These financially naïve beneficiaries need protection so the risk of loss should be exceptionally low near the target date. The Duty of Care is like our responsibility to protect our young children. Fiduciaries are liable for harm that can and should be avoided. Beneficiaries in the Risk Zone should be protected from investment losses.
Conclusion
The “Roaring 2010s” have set the stage for a “Depressing 2020s” when high-flying TDFs will crash. The “Roaring 20s” set the stage for the Great Depression. The price of prudence has been below average TDF performance, but that will change. The best fiduciary protection is beneficiary protection.
Ronald J. Surz is co-host of the Baby Boomer Investing Show and president of Target Date Solutions and Age Sage, and CEO of GlidePath Wealth Management. Target Date Solutions serves institutional investors, namely 401(k) plans. Age Sage serves do-it-yourself individual investors, and GlidePath serves individual investors who want an advisor.