Visionary Investing

Visionary Investing | Human Resource Executive Online Target-date funds are proliferating, evolving and receiving tougher employer scrutiny

Monday, March 2, 2009
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Target-date retirement funds have been put through their paces lately. Whether "TDFs" -- and, more importantly, the employees who invest in them through their 401(k) plans -- have emerged from the crucible of the markets' turmoil since late 2008 with their financial integrity intact may take several years to determine.

But the question is of no small import to HR executives who have begun embracing TDFs enthusiastically since 2006, when they became a permissible "qualified default investment alternative" for defined-contribution plans under the Pension Protection Act. If HR executives' growing faith in TDFs is misplaced, they will certainly need to pick another investment as their 401(k) plan's default selection to keep their employees' hopes of retiring some day alive.

Is that faith misplaced?

Assets in TDFs held within defined-contribution plans have mushroomed from $19 billion in 2003, to $137 billion in mid-2008, according to the Investment Company Institute. And ICI's tally of TDFs in existence today exceeds 300 -- most having sprouted up in the last few years.

"The PPA opened a whole new door for us," says Wayne Klieger, the head of financial compensation for AllianceBernstein, the 5,000-employee New York-based money manager and, itself, a large manager of target-date funds. In late 2007, the firm overhauled its 401(k) plan investment roster and designated target-date funds as the default investment for plan participants. All new deferrals would go to the age-appropriate TDF -- unless employees designated another option.

In addition to blessing TDFs as a default option, the PPA broadened employers' latitude in giving employees generic financial advice -- such as steering them to TDFs. PPA "gives you more of an opportunity to act in participants' interests," says Klieger.

The initial popularity of TDFs springs from the consensus that "the vast majority of participants are 'accidental investors,' " says Seth Masters, the chief investment officer for AllianceBernstein's defined-contribution group.

"They know it's important. They know they should be paying attention," he says. "They just don't have a clue how to go about it, so they're frozen into inactivity most of the time."

Moreover, employees' initial 401(k) investment choices upon enrollment tend to be influenced by recent stock-market performance, says John Ameriks, the head of the Valley Forge, Pa.-based Vanguard Group's investment counseling and research unit. "If it's been good, you see higher allocations to equities. If it's been poor, you see the reverse."

"The problem," Ameriks says, "is there is a tremendous amount of inertia -- the choices that are made at the beginning are not revisited for a long time."

Willing Converts

The promise of TDFs is that employees will benefit from the asset-allocation savvy of investment professionals -- as they would in a traditional pension. With TDFs, asset allocations are -- in theory, anyway -- capital-market- and age-appropriate, shifting gradually to a more conservative posture over time as investors approach retirement and become more vulnerable to the impact of market volatility.

AllianceBernstein's decision to move aggressively in the direction of TDFs for its own employees occurred in 2006, when the company recognized that many employees were overwhelmed with investment choices.

"When people are confused, they aren't going to leap into the pool," says Klieger. The company's 401(k) investment options were reduced from about 30 before the plan overhaul to 10 after the transition, Klieger says. Many employees found 30 investment choices simply too many to grapple with, he adds.

Still, the company's 401(k) participation rate was high -- around 80 percent -- even before the plan overhaul. But within a year, 96 percent of eligible participants had leaped into the pool, and about half of their 401(k) assets were invested in TDFs, versus only 10 percent prior to the makeover.

The high participation rate cannot be attributed to the TDF strategy alone, however. AllianceBernstein now not only automatically enrolls new employees in its 401(k), but non-participants already on the payroll are defaulted into participation annually, at a 3 percent contribution rate. If they stay in, their deferral rate will automatically jump 1 percent each year, to a maximum of 5 percent, Klieger says.

The plan overhaul that took effect in late 2007 included some anxious moments for Klieger. He had taken pains to inform employees that, unless they took the affirmative step of selecting a different investment choice, their future deferrals would all be funneled into the TDF corresponding to their age bracket.

On the eve of the conversion, he reviewed enrollment files to see who had designated other funds, to avoid being defaulted into a TDF. Klieger was worried when he discovered that many senior executives had not taken that step; he assumed that this was due to an oversight on the part of those presumably sophisticated investors.

"I called them up to ask if there was some mistake. But I found that there wasn't. Even at the top level of this money-management organization, there is a big appetite for the target-date approach."

Many employers fear that herding employees into TDFs will spark resentment. But, according to Masters, Klieger's colleague, that rarely happens. "The big shock for HR departments" when employees are defaulted over to TDFs, Masters says, "is that they get far fewer calls than they expected, and some of the calls they do get are from people who say, 'I want to thank you for making it so easy for me.' "

Michael Malone, a Phoenix-based 401(k) vendor-selection consultant, concurs. "We've seen about an 80 percent to 90 percent persistency rate" among employees who defaulted to TDFs, he says. "There is remarkably little blow-back."

Even so, not all employers are philosophically on board with pushing employees into particular funds -- even if they like the TDF concept. At Mestek Inc., a Westfield, Mass.-based HVAC equipment company, employees have access to a dozen TDF-style 401(k) funds through a Prudential Retirement Services offering called "GoalMaker." Technically, each of the dozen choices represents a cluster of underlying mutual funds.

Unlike the typical TDF, which employees select based on their age alone, the GoalMaker arrangement also lets employees pick fund clusters based on their self-determined risk tolerance (conservative, moderate or aggressive).

Dave DeBell, Mestek's vice president of HR, says Mestek employees are given educational materials and a quiz to help them assess their risk tolerance- -- which, in turn, assists them in picking the most appropriate fund cluster.

As employees age and reach the next age-based fund configuration, their fund allocations are automatically adjusted accordingly, but their risk tolerance categorization remains the same, DeBell says.

Also, employees who choose GoalMaker typically have all of their 401(k) dollars folded into the program, he says, because GoalMaker is more of an overall asset-allocation system than a set of individual target-date funds. "This allows employees to really connect the dots and see where their money is going," DeBell says.

The TDF Bailout

That level of understanding may have been lacking for employees at other companies whose TDFs took a pounding last year. As a result, many bailed out. "One of the biggest net sellers in 2008 was target-date funds," says Pam Hess, the director of retirement research for Lincolnshire, Ill.-based benefit consulting and outsourcing provider Hewitt Associates.

Hewitt's monthly "401(k) Index" measures fund flows. In December, 16 percent of all funds being transferred out of one type of 401(k) investment and into another were "lifestyle/pre-mix" funds.

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Overall assets in those funds dropped 27 percent over the course of 2008, according to Hewitt, but a significant portion of that decline may be attributable to asset depreciation, rather than a flight to safety.

Whatever the magnitude, some of the shift out of TDFs in 2008 may have reflected a lack of employee understanding of the nature of their underlying investments.

"I think what happened," says Hess, "is that people who were defaulted into them didn't realize they could go down [in value] that dramatically."

The higher the fund's equity allocation, of course, the more it would have been hammered in a year when the S&P 500 fell by 38 percent. And because TDFs are most heavily weighted to equities for employees whose retirements are the most remote, younger, new employees who defaulted into a typical TDF would have had the highest equity exposure -- and, thus, suffered the biggest loss.

And yet, TDF fund literature typically is very clear about the nature of the underlying assets, replete with colorful charts and graphs. The problem, Hess says, is that "this younger group of employees, who are heavy users of target-date funds, is a tough group to reach. They tend to be less engaged in 401(k) investing, and saving in general."

It's a bit of a Catch-22 situation. The fact that such employees are often tough to engage on retirement-investing issues is why many employers have resorted to defaulting them into TDFs in the first place, Hess says.

Still, she doesn't have a lot of qualms about the fact that younger employees -- engaged or not -- wind up with high equity exposures with traditional TDFs. "Generally, younger people have pretty vanilla financial situations, and as long as the money is going to be used for retirement, they're going to be fine."

However, as employees age, their investment requirements often vary widely, based on such factors as health, retirement income needs and their level of savings outside their 401(k).

And, as greater attention has been devoted to target-date funds' equity exposure, significant variations between the asset allocation models that different TDFs use -- especially those funds intended for employees close to retirement -- have been more closely scrutinized.

According to Baltimore-based 401(k) consultant David Huntley, until recently, "target-date funds were not sold or bought on the premise of performance. It was on the basis of a concept."

No more. The funds' so-called "glide path" -- the gradual shift of their weighting of stocks, bonds and cash over time from a mix emphasizing stocks in the early stages, to one emphasizing bonds and cash in the later stages -- is becoming a subject of acute interest to employers, Huntley says.

According to Craig Israelsen, a professor at Brigham Young University in Provo, Utah and a principal of Target Date Analytics, LLC, the four largest TDFs for employees at the threshold of retirement (2010 funds) had equity allocations ranging from 48 percent to 59 percent as of Sept. 30. (Israelsen and his colleagues have developed a set of benchmarks to help employers gauge the relative performance of their plans' TDFs.)

And when smaller, newer entrants to the TDF field are examined, the equity-allocation range is much wider, according to David Musto, a managing director of JPMorgan Asset Management. Musto's firm has developed an analytical tool dubbed the "Target Date Navigator" to help sort out the increasingly cluttered TDF landscape.

Whereas 401(k) vendors were once selected primarily on the strength of their record-keeping systems and the variety of their fund options, the growing importance of TDF offerings and greater concentration of employee dollars in those funds is shifting employers' focus to analyzing their investment characteristics in greater detail, Musto says.

TDF fund providers are ready to explain the nuances of their investment strategies and glide paths. But, Carol Waddell, director of product development at Baltimore-based T. Rowe Price, a large TDF manager, encourages employers not to lose sight of the bigger picture.

"Our conversations with sponsors are more about outcomes, based on what their employees are doing today, and how we can impact retirement preparedness. At the end of the day, that's what the retirement plan is all about," she says.

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