The S&P 500 gained about 2% during 2011. The Barclay's Aggregate Bond Index had an increase in the neighborhood of 8% for 2011. According to a Morningstar survey as reported by the Wall Street Journal, the average 2015 Target Date Fund (TDF) lost nearly 1/2 of one percent during 2011. To state the obvious, that's not good. At the end of this article, I'll give you one take on a solution. Until then, we look at the problem.
What's going on here? Shouldn't a plan participant within five years of retirement expect to do better? Or, are the funds in the 2015 TDFs allocated so as to avoid any significant losses at the risk of giving up the upside?
I am not in a position to analyze the contents of every 2015 TDF out there. I know about a few of them from having looked at prospectuses, in some cases because I had the opportunity to invest in them myself. But, I have also discussed the makeup of some of these funds with people who either sell them or manage the investments.
DISCLAIMER: What I am discussing below here are purely generalities about the TDF market. I am neither condemning nor endorsing any particular TDF. Further, my comments don't reflect information about any particular TDF. What you read into what I say is at your own peril.
Whew, it feels good to get rid of that disclaimer. I hate those things. On the other hand, I don't want to get sued for making an innocent statement that gets taken the wrong way.
First off, most of the large TDFs are proprietary funds of proprietary funds. What does this mean? Well, suppose you are invested in a TDF offered and managed by WSWAARGIC (that's We Say We Are A Really Good Investment Company for anybody who was wondering where the firm got its name that just rolls off the tongue). We will call them WSW for short. Take a look inside the WSW TDFs. Each one uses WSW equity funds and WSW fixed income funds. In fact, 100% of the assets in the TDFs are actually in WSW funds.
Now, we all know that WSW is a good money manager. We know this because our employer wouldn't have chosen them if they weren't really good. Just how good is WSW, though? In looking a little bit deeper, we see that the WSW 2015 Fund is invested in 7 distinct asset classes through 7 WSW funds. Of those 7 funds, 4 have been top quartile over the last 5 years. That's pretty good. Another 2 have been in the second quartile over that period. That's not bad. But, the seventh fund has been in the bottom quartile. It's the so-called Core Bond Fund and it makes up a good portion of the allocation for the 2015 Fund. The problem is that WSW doesn't really have a fund to replace it in the TDF and WSW insists that this is a short-term blip and the Core Bond Fund will improve.
As someone who plans to retire in three or four years, how do you feel about this? I'd bet that you wish they had worked out the Core Bond Fund problems outside of the TDF and replaced it with some other company's core bond fund.
But, most TDFs don't work that way. The managers tend to look for what they think are the best available investment options WITHIN the proprietary group of funds. Some observers think that they may not even be looking for the best, but just the most expensive, but I'll leave that for the reader to decide.
I'm going to go under the assumption that if you as a plan sponsor are using a TDF as your qualified default investment alternative (QDIA) that you think it's the right choice as a QDIA. Even so, are you in the right TDF? Suppose that instead of a proprietary TDF, you had a custom TDF consisting of (we'll use 7 as the number again) seven funds in seven asset classes where all seven funds were relatively low-cost, yet historically high-performing funds that have not had recent manager changes or other disruptions. These funds exist. Morningstar might call them 5-star funds. With this TDF, you would need someone to help you set it up, manage it and rebalance it, but all that can be done. From a participant standpoint, they would get better funds for lower fees ... and isn't that what a 401(k) plan is supposed to provide?