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.

Distribution Patterns from 401(k) Plans

I read this morning about target date funds (TDFs) being designed to match up with patterns of distributions that participants are taking. The understanding of these patterns of distribution has been discerned from actual participant behavior. This is good.

Loyal readers though know that I rarely write about anything that's good. So, what's up? Why is John wasting his time on this topic?

As we all know, the past may not be the best predictor of the future. Over time, it may be, but not necessarily in the short run.

If we consider older workers -- for this purpose, I'm going to use this term to apply to anyone in the work force who is at least 50 years old. What do we know about them?

• Many of them have accrued benefits in defined benefit (DB) plans, even if the plans have been frozen or terminated recently.
• A reasonable number of them experienced the insane run-up in equity markets during at least part of the 90s. I don't think we will ever see anything like that again.
• Very few of them have much, if any, money in Roth accounts.

All of this is changing. The wave of the future is much more likely to be that participants have more money in Roth accounts, that they do not have the annuity stream from DB plans, and that very few have surpluses from a prolonged bull market.

As most of you know, currently, penalty-free distributions are generally available as early as age 59 1/2 and required distributions begin at age 70 1/2. When these provisions were put into the Internal Revenue Code, many participants were retiring before age 60 and few worked even close to age 70. Today, this is not the case.

It occurs to me that in the future, participants are going to need a more systematic means of distribution that can be delayed significantly. Part of it leads to new designs of TDFs. Part should lead to changes in the Code.

I plan to comment more on these topics in the future, but that's it for today.

Building a 401(k) Plan that Prepares Employees for Retirement

It's one of the biggest concerns that I hear from people in 2012: "How will I ever be able to retire?" They tell me that their dad had a pension plan and Social Security, but they don't have a pension plan and they may not have Social Security. Whether these people will have Social Security benefits or not I can't tell you, but for most, their only employer-sponsored retirement plan will be a 401(k).

What does an employee whose only sources of retirement funds will be their 401(k) and Social Security need to do in order to ensure that he or she will someday have enough to retire? It's not rocket science, but it may not be easy either. Try this list on for size:

• Start saving early in your career. Money that is saved at age 25, compounded at just 5% annually will have more than double by age 40. But, at age 25, most people have other things in mind for their paycheck than their 401(k).
• Save continuously. Treat your 401(k) deferrals as if they will never be part of your paycheck. They are just money that is not there. In today's economy, that's not easy. When your expenses exceed your income, one way to cover that gap is to cut back on your 401(k). And, in these economy, more people than not seem to have an employment discontinuity. Just as employees don't have the loyalty to their employers that was once the norm, neither is the reverse true. Layoffs come frequently and re-employment is difficult.
• Invest prudently. Especially with the communications that plan participants receive, most of them have no idea what it means to invest prudently. They receive more advice than they know what to do with while their personal filters are not good enough to know which advice they should follow. One rule of thumb that I see frequently is that the percentage of your account balance that should be in equities is 100 minus your age. But, equities are volatile, and that has an effect -- a dramatic effect.
• Reduce volatility. Gee, John, didn't you just tell me to invest heavily in equities when I'm young, but that those investments are volatile? Actually, I didn't; I simply pointed out a common theme among the advice that plan participants receive. Consider this. Suppose I told you that in Investment A, the $1,000 that you deferred at age 25 would get an annual return of 5.00% every year until age 65, but in Investment B, your returns would alternate so that in the first year, you would get a return of -9.00%, in the second year, 20.00%, and that this would repeat itself until age 65. Simple math tells us that your average annual return would be 5.50%. So, which investment would you rather have (remember, these returns are guaranteed)? The answer is not even a close call. Despite the average return of 5.5% in Investment B, $1000 in Investment A after 40 years will accumulate to roughly $7,040 while $1000 in Investment B will accumulate to just $5,814. In fact, it would require the 20.00% return in the up years to increase to nearly 21.00% to make B as good an investment as A. Volatility is a killer.

So, the messages to the employees need to include 1) save early, 2) save continuously, 3) invest prudently, 4) reduce volatility. I would suggest that the first two items can be achieved for many people through auto-enrollment. But, most 401(k) plans that auto-enroll use a 3% deferral rate. 3% of pay is not enough. You'll never get there. Plans need to auto-enroll at rates closer to 10% of pay to ensure that employees will have enough to retire on. 10% is a lot. Many employees will opt out. It's going to be difficult.

The last two items relate to investments. The Pension Protection Act of 2006 (PPA) introduced a new concept to 401(k) plans, the Qualified Default Investment Alternative (QDIA). For employees who do not make an affirmative election otherwise, their investments are defaulted into the QDIA. Generally, QDIAs must be balanced funds or risk-based funds. Many plan sponsors use target date funds (TDFs) to satisfy the QDIA requirement. I went out to Morningstar's website to look at the performance of TDFs since the passage of PPA. All of them have had significant volatility. This is not surprising, of course, since equity markets have been extremely volatile over that period. But, we saw just a few lines up what volatility can do to you. Perhaps employees should be opting out, but into what? It's going to be difficult.

So, what are the characteristics of a 401(k) plan that guarantees employee preparedness for retirement? Many would argue that this 401(k) plan may not be a 401(k) plan at all. Perhaps what employees need is a plan that has some of the characteristics of a 401(k), but not all of them. Employees need to be able to save. Employees need portability as they move from one job to another. And, then, employees need protection against volatility and protection against outliving their wealth (longevity insurance). 

Consider that last term -- longevity insurance. The second word is insurance. Insurance generally is attained by a counterparty pooling risks. An individual cannot pool risks. An employer with enough employees can. An insurance company can.

Perhaps the law doesn't facilitate it yet, but a system in which employees can defer their own money to get a guaranteed rate of return (tied to low-risk or risk-free investments) and then have the amounts annuitized at retirement is the answer. Perhaps the law needs to facilitate it.

Another Sub-Par Year for Target Date Funds -- What to do Now

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?

And the Survey Says ...

I read the results of a survey on defined contribution (DC) plans this morning. Among its findings was that participants understand what the number/date in the name of a target date fund (TDF) means. I don't want to call out the name or author of the survey here because it did have some good information. What I do want to cite is that the conclusions may not be as valid as the authors suggest.

I'll bet you want to know how I can say such a thing. Even if you don't, I am going to tell you. Roughly what happened was that survey participants were contacted by telephone and asked a series of questions. One of those questions was (approximately) asking what the 2030 means in the term Retirement 2030 Fund. Again, approximately, the choices were:

1. The approximate date at which a participant expects to retire and begin drawing down the account balance for retirement income.
2. The approximate date at which a participant expects to retire and roll over the account balance to an IRA.
3. The approximate date at which the participant wants to spend the money freely.
4. I don't know.

Frankly, two of these (1 and 2) sound like good choices. The other two do not. That person could somehow divine one of the two correct answers (1 and 2) from the four choices given does not suggest much about the person. The survey authors seem to think it does.

I think I could have authored the survey in a way that would have shown that nearly 100% of respondents understand what the 2030 means. That's right, nearly 100%. 

I want to change the choices. I'll keep #s 1 and 2 as they are. But, I am going to change #s 3 and 4 to be these:

• The next year that the Cubs will win the World Series.
• The next year that NBC will win the ratings battle against ABC, CBS, and Fox.

See how silly it can get. Everyone knows that the Cubs just don't get to win the World Series. There is a curse, and it is stronger than the one that plagued the Red Sox. And, clearly, NBC is more likely to finish 5th in a 4-horse race than it is to win the ratings battle. 

Or, I could make these choices 3 and 4:

• The year at which a participant will have enough money in their account to retire comfortably.
• The year at which the fund will convert from an account balance to a level annual retirement payout.

Now, my guess is that between 50% and 60% of respondents would get this one right. And, remember, if choices were chosen randomly, 50% would choose either 1 or 2. So, I don't think that respondents really get it.

There is much education still to be done.

Of Course It's Time for a Better QDIA

The Pension Protection Act of 2006 (PPA) brought us lots of new terms and concepts. One of the more controversial has been the qualified default investment alternative or QDIA. Essentially, what it did was to require participants who did not make affirmative elections otherwise in defined contribution (DC) plans to be defaulted into a QDIA. On an ongoing basis, and oversimplifying somewhat, the Department of Labor (DOL) regulations give plan sponsors three broad alternatives in selecting their QDIAs:

1. Age-based funds
2. Risk-based funds
3. Managed accounts

Our observations suggest that the most prevalent have been age-based funds, largely in the label of Target Date Funds or TDFs. In a nutshell, a participant picks a year in which they expect to retire, rounds to the nearest multiple of five, and voila, they have a fund. Or, in the situation where a participant is defaulted into a TDF, the plan document uses the same algorithm and without the active consent of the participant, his or her money is in a fund.

The companies that serve as both DC recordkeepers and asset managers love this. To my knowledge, they all have TDFs that they actively market as part of their recordkeeping bundles, and each of these families of TDFs are proprietary funds of funds. In other words, a Fidelity TDF is composed of Fidelity funds and a Vanguard TDF is composed of Vanguard funds. The same could be said about the other asset management firms who are also DC recordkeepers. Perhaps there are one or two out there that do not fit the mold, but I am not aware of them.

This is not to denigrate the current state of TDFs, but I think we can do better. And, so, in fact, do plan sponsors. In a November 2010 study commissioned by PlanSponsor and Janus Capital, only 34% of plan sponsors (down from 57% in November 2009) thought a TDF was the best QDIA available for their DC plan. Or, stated differently, nearly two-thirds of plans (clients) don't like the product that is being pushed upon them. If you were a car manufacturer and two-thirds of potential consumers didn't like your product, you would likely need a bailout. If you made computers and two-thirds of the users thought your machines had the wrong features, you would need to re-think what you were producing.

Well, the large players in the market don't appear to see the motivation to re-invent the TDF, so as I am wont to do, I am going to consider the re-invention for them.

Today, when a participant is defaulted into a TDF, the sponsor (and recordkeeper) uses one data item to make that decision -- age. You would think that was the only data point they had. Well, if Bill Gates and I were both in the same DC plan, we would probably both be defaulted into the 2020 Fund. And, trust me, Bill Gates and I are not in the same financial circumstances. I know you find this shocking, but it just isn't so. The fact is that we do not have the same net worth as each other (I'll leave it up to my readers to work out who is worth more).

But, assuming that we were active participants in the same plan, here is some other data that our plan sponsor would have on us:

• Compensation
• Years of service with the company
• Account balance
• Rollover balance
• Savings rate
• Gender
• Whether our jobs are white-collar or blue-collar
• Accrued benefit in a defined benefit (DB) plan, if our employer sponsors one
• Whether we are eligible for company-provided equity

Each of these is likely to have an effect on our readiness for retirement at any point in time. Let's go through them quickly to see how.

Compensation. That's an easy one, but in general, the more money that an individual makes, the more likely it is that they will be able to retire earlier as compared to later.

Years of service. Continuity with the same company tends to result in larger DC account balances and larger DB accrued benefits making it more likely that a participant will be able to retire at a younger age.

Account balance and rollover balance. The bigger your balance, the closer you are to your retirement goal.

Savings rate. The more you are saving, the less time it will take you to get from where you are to your retirement goal.

Gender. Without regard to other factors such as health and family history, women will, on average, outlive similarly situated men, and therefore need a larger account balance to fund their retirements.

White-collar or blue-collar jobs. Studies done by the Society of Actuaries have shown that white-collar workers outlive blue-collar workers. This suggests that white-collar workers need larger account balances at the same retirement ages.

And, the other two elements may do more to affect the appropriate asset mix for a participant.

Accrued benefit in a DB plan. Accrued benefits in a DB plan can be thought of as a fixed income investment. That is, their value grows (largely) at a discount rate. Having a large DB accrued benefit means that the remainder of a participant's account balance could, and perhaps should, be invested more aggressively.

Access to company provided equity. If a meaningful portion of your compensation is in the form of equity, then you tend to possess a significant undiversified asset. This would suggest that your TDF should have significant diversification.

Again, who has this data? Your employer, the plan sponsor does. Combined with age, this list of parameters could give your employer ten data points with which to appropriately place you in a TDF instead of one. In the coming world of TDFs, this is what should happen.

Perhaps the TDFs of the future will not have years attached to their names, but instead will have letters, numbers, or some combination of the two. And, perhaps, these ten data items (or others like them) can be used as part of an algorithm to place participants into their proper TDFs. 

Finally, while we are redesigning, do we really think that any one asset management firm has a monopoly on all the best funds? I don't think so. Without naming names, I have an opinion on some of the best fixed income funds available in the marketplace. Surprisingly enough (not really), none of the firms that manages those fixed income funds also has, in my opinion, the best large cap equity funds, international equity funds, and real estate funds. So, wouldn't our new age TDFs be better if composed of funds from a variety of providers? I think so. And, if we suddenly had reason to believe that the great-performing real estate fund that we were using in our TDFs might no longer be as great (the main portfolio manager decided to retire), wouldn't we like to have the ability to change real estate funds? I think so.

It's time. Who is going to start the trend?

Customizing Target Date Funds

A recent study conducted by PlanSponsor and Janus Capital informed me that only about 1/3 of 401(k) plan sponsors (I think the actual number cited was 34%) think that Target Date Funds (TDFs) are the best Qualified Default Investment Alternative (QDIA) available. A year earlier, 57% were so enamored. That means that during a year that TDFs did not perform badly, approximately two-fifths of those who were on the TDF bandwagon fell off.

Why is that? Frankly, I'm not sure. The survey didn't ask them. Could it be that participant reactions to poor account performance come about a year in arrears? In other words, is there a natural time lag that occurs before the plan sponsor gets beaten up that goes something like this?

• Account balances decrease meaningfully
• Participant sees quarterly statement
• Participant finds last quarterly statement and compares
• Participant figures out which investment option he is in
• Participant asks 10 best buddies who to complain to
• Between them, they narrow down to the right person
• Complaints start pouring in 
• Plan sponsor sours on TDF as QDIA

Even in the best of years, however, one could question whether TDFs are an appropriate default investment vehicle. In the Pension Protection Act of 2006 (PPA), Congress came to a four-step conclusion:

1. 401(k) plan Participants who don't make an affirmative election regarding their in-plan investments should be defaulted into an appropriate fund
2. That fund should not be the same for all participants
3. Instead, it generally should be appropriate and the same for all participants of the same age who think they will retire roughly at the same time
4. It should be constructed in a way that is appropriate for a participant of that age

It left a few options out there. The investment manager who develops the TDF gets to decide what is an appropriate asset mix. A firm who is both a recordkeeper and an investment manager can nearly force a lot of money into their TDFs (some do this far more than others). A TDF can be 100% proprietary; that is, the TDF created by Really Powerful Investment Manager (RPIM) can be nothing but a mix of RPIM funds that already exist. TDFs need not take any parameters other than expected retirement year into account.

This cannot be the best answer. I repeat, this cannot be the best answer.

When I become President of the United States, a majority of both houses of Congress, and Secretary of Labor, it won't be the answer. Don't hold your breath waiting for any of that to happen. Even if I were an otherwise likely candidate for any of those positions, that I speak my mind freely in a forum like this would disqualify me.

So, consider this, the hint of the century (bonus points if you know who I stole that from, I'll tell you later). Not all 37 year olds who think they will retire in 2040 are similarly situated. Some have savings. Some don't. Some participate in defined benefit plans. Some don't. Some are homeowners. Some aren't. Some have kids. Some don't.

Let's just assume that the tie between recordkeepers and investment managers is not going to be broken. If that's the case, then proprietary TDFs will remain widespread. It may not be perfect, but I just can't see the whole industry losing its religion (that's a big hint, by the way). But, suppose that RBIM is the recordkeeper for the 401(k) plan that I participate in. And, suppose that the TDF family run by RBIM was the plan's QDIA.

But, let's throw in a few changes. Let's throw in a modeler. Now, each 37 year old who thinks they are going to retire in 2040 is going to tell a computer model something about himself. And, the model is going to take all this information and build a more appropriate TDF for that participant. And RBIM will change the name of its company to Really Excellent Manager (REM). 

Oh, and if you are looking for the answer to the trivia question that popped up earlier, you already have it.

IMHO -- Congress Got it Wrong With QDIAs ... Very Wrong

The Pension Protection Act of 2006 (PPA) was, in my opinion, a horrible piece of legislation. Frankly, it didn't protect many pensions and didn't do much else that, in retrospect, was very useful. One of the most well-regarded, at least initially, parts of PPA was the concept and requirement of Qualified Default Investment Alternatives, or QDIAs. In a nutshell, participants have their investments defaulted into a particular investment that is eligible to be a QDIA and unless they make an affirmative election to invest otherwise, there shall there assets reside.

The most popular QDIA has been Target Date Funds, or TDFs as they are usually referred to in the press. Most of the fund houses that offer them have one developed for each five-year age range. So, if you were born in 1970, for example, you will turn 65 in 2035, so you would get defaulted into the 2035 TDF. Some recordkeepers have gone so far as to say that if a plan's participants are not defaulted into their proprietary TDFs, then the sponsor needs to find a different recordkeeper.

This smells bad to me. And, it is.

I will probably explore this in more depth at some point, but let's consider some of what I view to be major flaws. First, as background, our 2035 Fund that we discussed is composed of assets in a broad, diversified group of asset classes. They are chosen to be appropriate for a person who is now 40 (or 41) years old who will retire in about 25 years at roughly age 65. Generally, its composition assumes that this pool of assets is their retirement income, perhaps in addition to Social Security. What is left out?

• For a random participant, is their current level of savings more or less than the norm for 2035 participants?
• Do they have outside savings? How are they invested?
• Do they have a defined benefit either with this company or with a previous employer? An annuity from a defined benefit plan can be thought of as a fixed income investment lessening the need for other fixed income investments?
• Does our participant have a working spouse? Does their spouse have a retirement plan? How is it invested?

There are many more, but bottom line, this Qualified DEFAULT Investment Alternative may be the correct default for only a small percentage of participants. Yet, all who don't make an affirmative election otherwise are defaulted into it. And, we haven't even talked about the fees and the specific funds that go into creating these funds of funds. The recordkeepers and fund houses will tell you that their TDFs are the greatest thing since sliced bread. I think otherwise.

Choosing Your DC Fund Lineup

How do you choose your defined contribution (DC) fund lineup? Do you follow best practices? Do you know what best practices are? More importantly, does your plan have an investment policy, and if it does, do you follow it?

I took an informal poll of some people on DC plan committees. Here are the questions that I asked them:

1. Does your plan have an investment policy statement?
2. If it does, do you follow it?
3. Would an impartial, outside arbiter say that you were following it?

The answers that I got surprised me, but perhaps I shouldn't have been surprised. To question #1, 14 people said yes, 5 thought they had one, and 1 didn't think they had one. To question #2, of the 14 who said yes on question #1, 9 answered yes, 4 were non-committal, and 1 said no. To question #3, of the 4 non-committal to question #2, all said no, and of the 9 who answered yest to question #2, 8 said no.

Perhaps the Department of Labor (DOL) would be an impartial arbiter. Perhaps a judge or jury would be an impartial arbiter. Only 1 in 20 thought they would get a seal of approval from such a person or group. That's pretty frightening, and the fact that I told each person that I questioned that my tallying of votes would be with tick marks only got some honest answers. Even in retrospect, I know the results of my poll, but I couldn't tell you who answered how. And, even if I could, I wouldn't. I won't tell you company names, industry classifications, or even the blood types of my respondents.

I took some time to reflect on this poll -- actually, I didn't take very much time. But, I did think about it. From my experience, here are some areas where I think that plan committees fall might short in following their written investment policy.

• They are too slow to 'fire' a fund. If a fund has a good name or historically has performed well, but then has a significant period of time where it inexplicably underperforms, committees are slow to replace it.
• They bow to pressure from recordkeepers to use proprietary funds because of the 'credits' that they get for it (lower recordkeeping fees because of a larger offset).
• They don't look closely at style changes/style drifts in funds. Oversimplified, if the investment policy says to offer one mid-cap value fund and one mid-cap growth fund and the value fund has gradually drifted to growth, committees are slow to replace the no longer value fund.
• They don't follow the investment policy when choosing target date funds (this one deserves a longer write-up than just a bullet point).

So, what's the problem with target date funds (TDFs)? They are not inherently bad, but especially after PPA (2006) established the concept of a qualified default investment alternative (QDIA) for which TDFs fit the bill perfectly, they became the next big money maker for everyone who could find an angle. For proprietary TDFs, most are just funds of proprietary funds, but the level of fees is a bit higher than it would be for someone who just invested in the proprietary funds and rebalanced periodically themselves. I guess what the participant is paying extra for is the discipline of rebalancing.

If you decide to have TDFs in your plan lineup, but don't want to use proprietary funds, there are plenty of people out there who will design TDFs for you. They will tell you that they will choose from among only the best performers in each asset class to create these custom TDFs. And, for that, they will often charge you a pretty penny. This, of course, will be in addition to the fees that participants get charged. From what I have observed, most of the providers who are offering this service don't have the discipline that the proprietary TDFs do. They may not rebalance quite on schedule. They may make bets on the market that are probably inappropriate.

At the end of the day, though, when you, as a committee member, are evaluating candidates to be the TDFs for your plan lineup, do you consider the plan's investment policy statement? Will you change TDFs if they are underperforming? For that matter, what does it mean for a TDF to underperform? Does your plan's investment policy statement tell you? Do you have a way of monitoring whether the TDF is staying true to its stated style, its stated goals? If you do have that way, do you use it?

In theory, TDFs are a wonderful idea. In practice, however, in my opinion, generally, they remain flawed. Some are better than others. And, they do tend to avoid haphazard practices such as market timing, but I have not seen one yet that some smart, unbiased person couldn't poke holes in. Does this mean that you, as a fiduciary, are in trouble once you put a family of TDFs in your fund lineup? It could, but it doesn't have to. Make sure your investment policy statement is clear with regard to TDF selection and TDF monitoring. Then, follow that policy statement, and document it. Did you read that part? Document that you have followed the investment policy statement.

If Not Target Date, Then What?

Last week, I wrote about a major problem with Target Date Funds (TDFs). I suggested that for many people, the targeting, and therefore the asset allocation, is incorrect. So, what would make it better?

The short answer, in my opinion, is that workers need to defer more income. And, the government needs to abet this process. Under current law, many individuals are limited in the amounts they can defer to a 401(k) plan. This occurs for one of a number of reasons:

• An individual bumps up against the statutory deferral limit of $16,500 ($22,000 including catch-up for those who will attain age 50 or older in that year)
• An individual bumps upon against a plan limit (usually put in place to assist in passing ADP and ACP testing (nondiscrimination testing for 401(k) plans))
• An individual defers as much money as the plan allows (or some other significant amount) and the plan is not able to pass ADP testing, so amounts are refunded

Those three reasons usually relate to higher paid people. For the lower-paid, they often cannot afford to defer enough.

I suggest that unless Congress (and the President) do something to both promote and provide an incentive for employers to sponsor more and more generous retirement plans, then employees need to better understand the plight that they face. Perhaps the government shouldn't build the model (suggesting outsourcing it here), but workers need to better understand how much they really need to save. Individuals need to be able to model their scenarios based on reasonable assumptions. They need to be able to input one-time and limited-time expenses. There should be suggestions as to assumptions with education as to why those assumptions (or range of assumptions) may be appropriate.

Then, perhaps, workers will understand when they will be able to retire. And, then and only then, might TDFs become appropriate as default investments (QDIAs) in 401(k) plans. 

Since ERISA was signed into law in 1974, the federal government, in my opinion, has done everything in its powers to gut the retirement income security system it claimed to be protecting. It's time for them to step up and tell the people how bad they've made it.

Do Target Date Funds Have it Bass Ackwards?

Target date funds or TDFs as they are sometimes known are all the rage in defined contribution (DC) plans. Perhaps, you have your money invested in one. Before I try to confront conventional wisdom, let me explain how they typically work.

Your plan account is set up on what is known as a glide path. What this means, oversimplified somewhat, is that your funds are invested in a diversified portfolio which is fairly aggressive at younger ages, and gets more conservative as it moves along the glide path toward older ages.

I'm not saying that this is wrong, but I'm going to challenge conventional thinking. I did a really simple simulation for 25 years. I assumed that a person started with annual compensation of $50,000, got annual pay increases of 4% per year, deferred 6% of pay into his 401(k) plan each year and got various rates of return on his money for each year. In the case where our hero earned a 10% rate of return in year 1 and 0% in year 25 with intermediate years sloping down smoothly, his account balance at retirement (end of Year 25) was about $182,500. When I assumed an annual rate of return of 5% (never varying), his account balance at retirement was nearly $223,500, and when I reversed the first scenario by grading upward from 0% to 10%, his account balance at retirement was just shy of $272,000.

But, the whole philosophy behind TDFs is to sacrifice potential reward for decreased risk as a participant approaches retirement. These illustrations imply that this is all wrong. Why? Well, the close that you get to retirement, the more money you have in your account. So, in Year 1, it probably doesn't make much difference what your rate of return is as there is a limit on what can happen to $3,000 deferral. But as deferrals and earnings add up, the annual rate of return becomes much more important.

This is too simplified for you, isn't it? Well, I made it more complicated. I developed multiple scenarios using a random number generator where the rates of return in Years 1 through 5 averaged 6%, in Years 6 through 10, they averaged 5.5%, in Years 11 through 15, they averaged 5.0%, in Years 16 through 20, they averaged 4.5%, and in Years 21 through 25, the average return was 4.0%. The mean ending account balance of all the simulations was about $192,000. Then, I reversed the process so that 5-year time-weighted returns averaged 4% in the first 5 years up to 6% in the last 5 years. Now, the simulated mean ending account balance was about $225,000.

Come on now. Don't do this to us. Don't mess with conventional wisdom. It hurts the brain on a Friday. What is going on here?

Let's step back and think about the underlying TDF premise. I'm going to point out a huge flaw in that premise (I'd love to be besieged with comments telling me why I am wrong). TDFs are designed so that the participant takes more risk and presumably gets more reward early in his career, and that is gradually reversed to the point where the participant takes less risk and gets less reward later in his career. This makes a big assumption which is usually false.

Read on, MacDuff!

The assumption made in TDF design is that a participant nearing retirement actually has enough money in his account that he no longer needs the upside potential that he needed when he was younger. In other words, it presumes that our participant has nearly enough money in his account to retire on as he nears retirement age, and that only some significant downtrends could disturb that.

We've all seen the data. It's just not so. Our participants rarely have enough in their accounts these days to retire on and they don't understand that. So, this de-risking strategy, while it doesn't make our participants significantly less able to retire when they plan to, also doesn't make them able to retire.

What is the answer? If I could snap my fingers and tell you, I wouldn't need to be sitting here blogging. I'd be out in northern California in my rocking chair looking out the window at my vineyard being tended to by others. But, I'd like to posit that DC plans need to learn something from defined benefit (DB) plan funding methods. I'm not talking about the current farce where all plans with pay-related benefits are forced to use a non-pay related cost method to determine contribution requirements. I'm talking about an old friend, Individual Aggregate.

If I've lost you now, I'm going to bring you back to the story. A long time ago in a faraway land (shortly after the passage of ERISA in the ivory towers of the Treasury Department), the IRS and Treasury were good enough to tell us in regulations and other guidance what constituted a "reasonable actuarial cost method." Individual aggregate was a favorite for funding one-person plans. It was constructed to produce a cost of a level percentage of pay throughout a participant's career so that a participant's retirement benefit would be fully funded at retirement, and the cost of deviations from assumptions were spread over the participant's remaining future working lifetime, so that the benefit would be fully funded at retirement. That's a really neat concept, isn't it?

What does it have to do with DC plans? Well, part of funding a DB plan is (or at least used to be before Congress starting meddling with funding rules) that the actuary makes a bunch of actuarial assumptions related to compensation, retirement date, mortality patterns (life expectancy), rates of return, and other related factors. Couldn't a participant in a DC plan do that?

So, a participant makes assumptions. He decides what percentage of pay he can defer to his plan, and through this fancy concept known as individual aggregate, he gets a necessary rate of return. Necessary rate of return is too high, he better defer more, or retire later. In any event, this would amount to sound planning.

Yes, for those who start early, defer a lot, and get a nice inheritance, TDFs will work well. Those participants will be prepared for pre-retirement in their pre-retirement years, and for them, downside risk avoidance will be paramount. But data shows that most participants are not in that situation. For them, I think we need to re-think TDFs.

Tell me why I am wrong. Tell me why I am right. Tell me something.

New DOL Target Date Fund Rules

In today's Federal Register, the DOL published new rules for target date funds in qualified defined contribution plans. Briefly, target date funds (TDFs) are pre-mixed funds of funds usually put together by mutual fund providers. They allow a participant to select an estimated or targeted retirement date (usually in 5-year increments) and put their money in a fund that uses a glide path (investment allocation policy) that becomes more conservative as a participant approaches their targeted retirement date. TDFs became exceedingly popular as the Qualified Default Investment Alternative (QDIA) of choice after passage of the Pension Protection Act of 2006.

You can find the DOL guidance here: http://www.ofr.gov/OFRUpload/OFRData/2010-29509_PI.pdf

Key guidance in the rule includes the following:

• Fiduciaries are relieved from certain fiduciary responsibilities in defined contribution plans if they follow the rules.
• Plan administrators must furnish participants and beneficiaries with certain information related to each available investment under the plan.
• That information must include:
• A narrative explanation of the glide path and a description of the point at which the TDF will reach its most conservative investment allocation. This is key in understanding whether the purpose of the particular TDF is to get participants to retirement or through retirement.
• A graphical illustration of the TDF's glide path.
• An explanation of the relevance of the TDF date; e.g., for a 2030 fund, what does the "2030" mean?

Again, this is probably a step in the right direction for TDFs in reaction to the precipitous fall in the value of TDFs in late 2008 and early 2009. But, the reasoning is wrong. Of course, TDFs can lose money. All investments can. The point is that retirement plan participants need to understand the decisions that they must make. This is good information, but if they don't understand that this is an investment that is designed to increase in value, but that could decrease in value, then we have gotten nowhere. 

Americans need to be more financially educated. Savvy is a good goal, but educated is a necessity. It's nice that we learn about the explorers in school (Columbus, Magellan, etc.), but wouldn't it be nice if we educated our students in financial topics as well? It's never too early to start, but for many workers, it's far too late. For them, perhaps the best they can do is to follow the sage (or not so sage if you prefer) advice of Ron Popeil (he of infomercial fame): "Set it and forget it." Unfortunately, there is his follow-up line: "Wait, there's more."