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By Christine Benz and Josh Charlson | 05-14-2012 01:00 PM

Recognizing Red Flags in Your Target-Date Fund

Morningstar analyst Josh Charlson helps investors size up 'glide path' changes in their target-date fund series, and also discusses recent target-date performance and fund flow trends.

Christine Benz: Hi, I am Christine Benz for Morningstar.

Target-date funds have grown quickly, and there were more than $400 billion in assets at the end of 2011. Joining me to discuss recent developments in the target-date world is Josh Charlson. He is a senior fund analyst with Morningstar.

Josh, thank you so much for being here.

Josh Charlson: Sure, my pleasure.

Benz: You recently prepared a very comprehensive report about the state of the target-date fund industry. I'd like to start with changes that you've seen in terms of how these funds are putting themselves together. There was a lot of criticism following the bear market. Some of the funds for investors getting close to retirement were quite aggressively positioned and lost a lot. What has happened in the target-date industry since then?

Charlson: There definitely have been some modifications, especially with some of the providers who experienced some of those problems you referred to. It probably falls in to a couple of categories. One is providers who reduce their equity in the glide path around that retirement date, sometimes a few percentage points, sometimes bigger. But we did see a number of providers who drop that equity exposure down.

Another area of change has been within the bond portfolios. A lot of the problems were not just on the stock side but on the bond side. So, some of the bigger offenders in the area have cleaned up their bond portfolios, got rid of some of that lower quality credit exposure, changed management in the underlying bond funds. With open architecture series, we saw a lot of people adding PIMCO Total Return as kind of a higher-quality bond exposure.

Benz: So, when you say open architecture that means rather than being wedded to the products from a single firm, the series are able to sort of go across the industry.

Charlson: Exactly. Some of the target-date series have that capability; many do not. And then the other area is--and maybe we can talk about this later--some have added more innovative tools, such as volatility-management tools and hedging types of tools, to combat some that risk at the end of the glide path.

Benz: One thing you talked about in your report, Josh, is what's call the Glide Path Stability Score. It's something developed by Morningstar Ibbotson, and it looks at the extent to which target lineups have actively changed their asset-allocation positioning. Let's talk about some of the things you found when you looked at those scores and looked across fund lineups.

Charlson: This is some great research that Morningstar Ibbotson did, and we kind of broke it down a little more and looked at the series and looked at the numbers. Really what they are looking at is, how much have providers actually changed their glide path over time. So, it's not just the normal shifting of that allocation as you get older, but actually changing the curve over time from one point to another. They found that there has been significant change. That's not necessarily a bad thing. Some providers have changed more than others.

What we found is that you kind of have to look and see what were the reasons for the change and how well has a provider communicated that. It makes sense that over at some of the longer-tenured series like let's say Fidelity, they are going to have made changes over time because asset-allocation philosophies have changed. If you're an owner of a target-date series and you take a look at those numbers, it kind of raises a flag for you to say, "Has there been more change than I expected, and does that mean that this might not look like the same target-date fund that I own today 10-20 years from now?" That could be a concern.

Benz: So, can you give an example of a situation where a lot of volatility in that glide path would be a red flag?

Charlson: Probably it would be in a case where it seemed like the managers were being reactive. Maybe they added equity a lot in 2005-06 and kind of got more optimistic about the stock market. Bad things happened in 2008, and they said, "Maybe we don't believe that story so much anymore." Maybe it makes sense, but you might question a little bit the rigor of their methodology, their commitment to their methodology. By contrast, T. Rowe Price has one of the more aggressive glide paths. It always has. Even after 2008, it didn't budge on it all, and it shows one of the more stable Glide Path Stability Scores.

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