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Recognizing Red Flags in Your Target-Date Fund

Christine Benz
Josh Charlson, CFA

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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Benz: Now, I would like to shift gears and talk about performance. It's obviously a very broad basket of different products with different levels of aggressiveness. But can you kind of generalize about within the target-date universe, what types of products, what lineups, have generally outperformed and which have underperformed since you've been tracking them?

Charlson: Sure. As you said, it's been kind of an unusual market that has been sort of dominated in the sense by the down periods, and 2011 was in some ways indicative of that. The series that did best in 2011 were those that have more conservative management philosophies. So, providers like Wells Fargo and American Century, as well as some newer ones like Invesco and Allianz, all did well. If you go backward and look over the five-year period, those more conservative series really have done the best as well because for those that held up better in 2008, that's just carried over that five-year period.

Now, there are series that have more industry-average or even more aggressive glide paths that have done well too because their underlying funds have done well or they have done well on a tactical basis. So, T. Rowe Price, again, is an example of that. They have done much better than other comparably aggressive series because their funds have performed so well underneath. Vanguard, of course, is an index-based series, one of the largest. Their performance has been pretty good, too. Being benchmark-aware or close to the benchmarks has helped more than being extended in diversification, even though over the long-term diversification should help. The last few years if you had emerging markets, if you had lower-quality credits, or if you had certain other commodities, that's hurt you more than it's helped you.

Benz: Now, let's talk about fund flows, and you mentioned Vanguard, Fidelity, and T. Rowe Price. You call them in the report the Big Three because they really do dominate this universe. Are there any other firms that are making a strong showing and gathering assets even though they are not necessarily giant firms?

Charlson: Yes, there are. No one is likely to step into the territory that those Big Three are, but there are firms that have made good ground on them. JPMorgan is an example of one. They are up to about $5.5 billion when we counted at the end of 2011. Their organic growth rate, that is their growth rate apart from market appreciation, has been very strong. One the reasons they've been one of the most consistent on a performance basis. 2011 wasn't great for them, but for the previous three years despite different markets, they were up there in the top echelons of the categories each year.

There are some smaller providers that are making a little bit of noise. Again, they're not going to jump up into the top 10, but through different types of strategies, they've made some distinctive appearances. PIMCO is one of the smaller ones, but they were one of the fastest-growers last year. They have a very unusual strategy that emphasizes real return for investors, so they have high allocations to commodities, real estate, and Treasury Inflation-Protected Securities, for instance.

Maxim is not maybe a household name. They are distributed by Great-West. They have a very extensive lineup of outside subadvisors that they use that seems to be an approach that has some appeal to plan sponsors. They've grown at a faster rate.

Benz: Another thing you touch on, Josh, is the growth of index-based target-date funds, that they are gathering assets at a greater clip than those that use more actively managed products. What do you think is going on there? Is that just sort of mirroring the trend that we're seeing in flows in the mutual fund and exchange-traded fund markets generally?

Charlson: It could be part of that. There are some specific competitive pressures within the target-date industry, and cost is one of those. Plan sponsors are very concerned about costs, so index offerings obviously are lower-cost. Frankly, because of the lower tracking error, after 2008 there has been a little nervousness on the part of plan sponsors. Index-based offerings do take away that active manager risk.

As you said, we noticed that they are growing at a faster rate. Certainly, they're still a small portion of the industry as a whole. The other thing that's interesting is that there are providers who have actively managed offerings out there that are putting in index based target-date series along the side of their active offering to give people a choice in the marketplace.

Benz: The last thing I'd like to touch on, Josh, is the disclosure going on in the target-date universe or some proposals to add some disclosures for target-date fund participants. Let's talk about what those are and also whether you think that they are good steps forward in terms of the information that target-date participants get.

Charlson: Sure. The SEC has opened a comment period again on its proposal to have some additional disclosure requirements, primarily for marketing materials. One of their top-billed items is adding the allocation of a target-date series at the retirement date in the name of the fund.

Now, every year in our industry survey, we look at the disclosure of the 22 series that we cover with analyst ratings. So, we have a pretty good idea of what's out there, what they are doing well, and what they are not doing well.

What we would like to see is a requirement of an illustration of a glide path in every prospectus that really shows visually how that allocation will change over time. Our concern with just putting the allocation of the target date in the name is that it's just one point, when really the allocation before retirement and after retirement can be important.

We would also like to see a more detailed list of allocations in the prospectuses, where you really get down to levels of bonds within the bond category, within the stock category, commodities, and alternatives, so you really have an idea of what the targets are for those managers. Finally, something we would like to see a better job done on is disclosure about tactical allocation, what sort of bands of deviation from those targets can managers take. Generally, we have not seen great disclosure in that area.

Benz: Well, Josh, thanks for this very thorough overview of this very fast-growing category. Thanks so much for being here.

Charlson: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for