Wednesday, February 11, 2015

Custom Design Your Target Date Funds

Target date funds or TDFs have been around for a while. They've carried a bunch of different names, but at their most basic level, they are intended to allow a defined contribution (DC) participant, usually in a 401(k) plan, to have their assets properly invested based upon the participant's approximate assumed retirement date (for example, a person who is 50 today and plans to retire at age 65 would likely be instructed to invest in a 2030 fund).

TDFs became really popular after the passage of the Pension Protection Act of 2006 (PPA). PPA introduced the concept of the Qualified Default Investment Alternative (QDIA), the fund into which a participant's assets default if the participant does not make an election otherwise. Regulations issued by the Department of Labor (DOL) specifically sanctioned TDFs as QDIAs and they took off.

So, what's the problem? TDFs are professionally managed, the glide path (asset mix that changes and becomes more conservative over time) is developed by people expected to have expertise (specifically refusing to designate them experts), and the asset mix is rebalanced periodically (often quarterly) to ensure that a participant's asset mix stays near to the targets established in the glide path.

That's all good stuff.

I will tell you where it breaks down, but first we digress for a break for some lexicon. In the TDF marketplace, there are generally two types of funds, "to funds" and "through funds" -- to funds assume that a participant will take his money out at retirement while through funds assume that a participant will leave her money in through retirement only gradually drawing it down. Salespeople for the larger recordkeeper/money managers will tell you the benefits of their philosophies of to or through which ultimately have a significant effect on your glide path.

Just as TDFs are to or through, the underlying funds used to help effect the glide path are either actively managed or passively managed (often index funds). Actively managed funds charge more for their investment services. Salespeople will tell you how their managers absolutely obliterate their benchmarks. Most of those managers don't.

Finally, wouldn't you expect a really good TDF to be composed of the best funds in each asset class? They're usually not. Usually, they are composed of proprietary funds of the TDF asset manager. And, it's not unusual that they use proprietary funds that are not even the best of their own for that asset class.

Said differently, TDFs are huge moneymakers for the recordkeepers/money managers. They may not be moneymakers for the participants and, in fact, they are likely not even designed for the participants.

In a better world, participants could build their own TDFs. I wrote about this to some extent way back in 2011. And, now that I have flogged the existing proprietary TDFs into oblivion, it's time to discuss them again.

In 2015, we have tools, lots of tools. We have them on our computers, on our phones, on our tablets and phablets, and some of us even have them in our watches and glasses. The fact is that technology changes virtually daily and almost all of us have access.

Suppose we had a tool into which participants could enter their own data and build their own TDF structure based on that data. The tool would ask about things such as your savings outside of that DC plan, the age at which you actually expect to retire, whether you have any defined benefit (DB) annuities coming your way (they are, in effect, fixed income investments), how long you expect to live based on what you know about your health and your family history, major expenses that are coming up, the large inheritance that you expect, and other similar relevant data. From that and some additional questions, our handy dandy tool (I think I'll call it HAL since that name worked for a computer way back in 1968 (think movies if you are confused)) will develop glide path and portfolio specifically designed for you.

In fact, HAL will even rebalance to keep you on your glide path, and HAL will be smart enough to take risk for you if you are falling short of your targets and diminish risk for you if you are ahead of your goals. But, HAL cannot exist for a proprietary TDF. HAL does not like to fill up his TDFs with proprietary funds of the recordkeeper who sells you its TDFs.

HAL says, "Go custom!"

Let us know, we can help.

1 comment:

  1. Thanks John, great commentary on the ills of TDFS... I've written long and hard on their failings for a long time as well.

    I even went so far as to design an old fashioned, high quality balanced income portfolio as an offering to the 401k investment gods.

    No way they responded, making it clear to me that the product powers in the 401k space have no clear understanding of how to prepare a retirement income portfolio.... glide path my asterisk!