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Target-Date Funds Leave Retirees Out in the Cold

August 1, 2007
Related Topics: Compensation Design and Communication, Benefit Design and Communication, Latest News

Until now, target-date funds have been designed to manage investor assets up to, not through, retirement—a flaw that could leave many retirees broke or taking on excessive risk in their golden years, according to a study released Monday, July 30, by Wilshire Funds Management.

The study of target-date funds, or lifecycle 401(k) funds, which are diversified asset-allocation portfolios that rebalance over a specific period of time, found several faults with the offerings currently being peddled by other investment companies.

For starters, target-date funds fail to accurately estimate individuals’ income needs, or liabilities, as they move from their working years to retirement and beyond. Some funds switch their asset allocation to a conservative mix too soon, which could leave individuals who live far into retirement underfunded.

Other funds have lengthened the investment horizon into the retirement years but have failed to consider risk: The funds are typically overly concentrated in equities, which means investors could find themselves suffering large losses near, or in, retirement and have no chance to make them up, according to the study.

“If you look at the approaches out there, they don’t look at an investor’s liabilities,” says Wilshire vice president Matt Radgowski. “They look at some equity glide path that’s based on the risk and return of the portfolio without making any type of assumption as to what income needs those types of individuals will actually have in retirement.”

Wilshire’s remedy: The firm claims to have come up with a model that takes target-date funds to the next level. It has developed what it calls a proprietary technique for constructing target-date portfolios that take a more conservative or aggressive asset-allocation approach, depending on whether an individual is underfunded or sufficiently funded in their retirement accounts.

In Wilshire’s setup, Treasury inflation-protected securities, or TIPS, become an important component of the portfolios as investors approach retirement because of their inflation-hedging characteristics, Radgowski says. Other alternative investments will also be used, including commodities, real estate investment trusts, emerging-markets equities and high-yield debt. Radgowski says Wilshire will work with investment management companies to determine the desired asset classes for the funds, as well as the fees.

Earlier this month, Los Angeles-based fund company Payden & Rygel launched a series of four target-date funds (2010, 2020, 2030 and 2040) using Wilshire’s research, called the Payden/Wilshire Longevity funds. The total annual expenses for the funds are 1.4 percent of net assets.

The portfolios are also designed using a changing life expectancy model in order to better manage longevity risk, a tool Radgowski says many other funds lack.

“It’s certainly a unique offering and something financial planners have been discussing doing,” says Tom Roseen, senior research analyst at Lipper. “Obviously it doesn’t make sense to take 100 percent of our assets that we’re not going to use for 15 years and put them in a money-market fund. Some of that should probably be in rock ’n’ roll funds.”

Of course, Wilshire isn’t the first to find deficiencies in the target-date fund world, which has been growing by leaps and bounds. Earlier this year, JPMorgan Asset Management released a study claiming that fund companies designing lifecycle funds are using overly optimistic assumptions of investors’ contributions, and suggested that using alternative investments in such funds would help retirees improve their 401(k) returns.

“Everyone is trying to make a mark in the whole target-date world,” says Tom Modestino, a senior analyst with Boston-based research firm Cerulli Associates. “There’s always a new target-date story, but ultimately what’s going to differentiate these funds is how they’re priced and how well they perform, which is a total mystery right now.”

Investment in target-date funds has soared as many investors lacking the investment chops or interest have poured their money into them because they’re easy to understand, set up and monitor. According to Morningstar, assets in these funds have grown from just $26 billion in 2003 to more than $116 billion through 2006.

And they’re on track to more than double that amount this year: Roseen notes that flows into target-based funds this year hit $67.2 billion for the year through June, just shy of the inflows into popular world equity funds, which captured $75.5 billion during that same period.

“These funds are the lion’s share of where money is going,” he says. “They’re the buzz topic for the industry right now.”

Filed by Jeff Nash of Financial Week, a sister publication of Workforce Management. To comment, e-mail

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