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The following are some commonly asked questions and concerns I’ve heard from advisors about 401Ks, target-date funds and retirement.
1. Are target-date funds (TDFs) a good thing or a bad thing?
A little bit of both. They are easy for investors and reduce the burden for plan sponsors. For money managers, it increases participation and assets go up. But, there have been problems when performance has disappointed.
2. Why do you think TDFs are outdated? What needs to change?
They are facing some challenges and they must change their thinking. The investment environment is not pretty. When you look at stocks or bonds, neither looks particularly attractive today. Stocks are at an all-time high. People are nervous. With bonds, yields are low. Should interest rates rise, bonds are susceptible to losses.
People need to think about the big risks – a systemic selloff in stocks or bonds, or both. TDFs do not protect as much as they should in bear markets. We saw that during the financial crisis. The most conservative TDFs lost, on average, 31%. Aggressive funds were down more. Advisors need to think differently about their investment options. TDFs need to do something about that market risk.
3. TDFs are often the default investment option for 401K plans that we recommend. Is there anything wrong with this “set it and forget it” approach?
TDFs are designed to make it easy. The flaw is that people try to make retirement planning too easy. Spending time with participants to go beyond the “one-click” solution of choosing a TDF. The investment in a 401K plan is only part of the overall picture. Investors should consider if their TDFs are within the context of an overall financial plan. Dig deeper with your clients to educate them. Focus on getting people actively thinking about factors that go into retirement. The first step is not the last step.
4. What can we do to educate clients on 401K investment options? We consider this a value-added service.
Advisors need to put financial concepts into real terms, not just numbers. We tend to be numerically illiterate as a society. Make it real. Concepts like risk and reward need to be translated into real world cause-and-effect scenarios. This is a human problem of making rational decisions when people are too frequently driven by emotion.
5. Given that 2010-vintage TDFs had significant losses in the financial crisis, is there a next generation of TDFs to consider so clients will not be disappointed?
We anticipate there will be other major selloffs in the future and we are actively addressing that. We think TDFs should look to hedge market risk. Giving up a little on the upside is fair to offset a potential selloff of 30%-40% or more.
A better TDF that seeks to mitigate downside risk is where we should be moving.
6. Can investors whose retirement plans are underfunded afford a strategy that limits the upside? And what about hedging – isn’t it expensive?
The temptation for investors late to the game is to “swing for the fences” and attempt to “hit a home run” with their investments in order to compensate for years of under-saving. This can be a desperate, potentially disastrous strategy. If you are late to the game, there is a catchup provision which allows you to save more. You should not take crazy risks to catch up. You need to protect what you have when you are in the late innings of the game. Mathematically speaking, if one can reduce the participation with the market on the downside, less upside participation may be required to outperform the overall market over full market cycles. So the cost to hedge a portfolio may prove to be worth the reduced upside capture, while potentially helping investors in the late innings of the game from suffering devastating losses.
7. Should I pay more attention to the investments in client 401Ks? Keep in mind that we need to offer clients a smooth, consistent return.
Advisors and plan sponsors scrutinize the TDFs they use and see how they are allocated. Within the same vintages, there are wildly divergent asset allocations among TDFs. There is no standard allocation for a conservative, moderate or aggressive TDF. Advisors need to take a deeper look. Seek out TDFs that are looking to manage risk.
8. How can we protect client accounts on the downside in this bull market?
Our answer is that if you can’t diversify risk away, you can potentially hedge it away. You give up some cash but you are passing on the risk because you don’t want to face a catastrophic loss.
9. What is a collective-investment trust (CIT) and how can it work in a 401K?
A CIT is similar to a mutual fund but set up a little differently. The investment portfolio is similar. What is different is that it is not registered with the SEC and as such, you cannot advertise or market CITs. Therefore, they can be cheaper. It is the same kind of product as an alternative to a mutual fund but often with lower costs due to many factors. If you are talking millions or billions of dollars, saving 10-30 basis points can be significant.
10. What are the pros and cons of CITs and TDFs?
In addition to lower costs, another advantage of CITs is some customization capability. If you are big enough, you can insist that your investments follow certain restrictions or specific criteria.
On the downside, unlike TDFs, it is not easy to find information on CITs. There are data providers that collect CIT information, but it is not easy or cheap to access. You have to have the right tools to do it yourself or talk to people who are sponsoring them. Advisors and sponsors can go to retirement conferences, talk with peers or read retirement trade publications to better understand CITs.
11. How do you think the DOL fiduciary rule will affect TDFs?
The DOL places too much emphasis on costs. My fear is that the DOL will encourage plan sponsors to offer only the cheapest TDFs available. “Cheapest” is not always “the best.”
In sum, TDFs are good, but flawed. It’s time to think about how we can fix and improve them with TDF version 2.0, which seeks to reduce market risk and smooth returns for investors.
Marc Odo is the director of investment solutions for Swan Global Investments, a Colorado-based SEC registered investment advisor providing asset management services.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
