Morningstar's To-Do List for Target-Date Regulators

Target-date funds are on the agenda in Washington, D.C., this week as the Securities and Exchange Commission and Department of Labor are holding hearings to investigate the investment strategies and disclosure practices of target-date funds.

With target-date funds, investors choose a fund whose name contains the year close to their expected retirement date. The funds' asset allocations shift gradually during the investors' careers, becoming more conservative as they reach their retirement dates. Target-date funds have become increasingly popular in retirement plans, a trend that has accelerated since 2006 when target-date funds became an approved default investment.

The trigger for the June 18 hearing is the abysmal performance exhibited by some target-date funds in 2008, particularly those with target dates near retirement. The hardest-hit 2010 funds lost as much as 41%--that's particularly painful for those investors who planned to draw from their retirement nest eggs within a few years.

A Focus on Disclosure, Not Performance
We think that the increased scrutiny of target-date funds is a good thing. It's understandable that regulators have been caught up in the alarming 2008 performance numbers, but we urge regulators not to get too caught up in this part of the story. Yes, risk-management practices fell apart at some of the worst-performing funds. But the average 2010 target-date fund in our universe lost 23%, certainly not a figure to rejoice over, but not altogether catastrophic in a year when the S&P 500 Index lost 37% and many non-Treasury bonds got hammered in an environment of poor liquidity and credit downgrades. Shorter-dated target-date funds were never intended to be risk-free investments; most invest substantial portions of their portfolios in stocks so that investors' savings may grow more substantially in the decades following retirement. Thus, these funds are not immune from the potential risks and volatility of the equity markets.

The bigger issue, in our view--and the one where governmental agencies can have the greatest impact--is disclosure. Most fund companies have done a poor job of communicating to investors just how their target-date funds are put together, what sort of risks those funds take on, the philosophy behind the construction of the funds, what the target date in their name actually means, and how their particular target-date series is distinctive from others in the industry. The SEC and DOL can push fund companies to do better, and specifically, here's what we'd like to see ...

1. A true, detailed breakdown of funds' glide paths.
Most fund companies make available to the public only the broad asset classes in their glide paths--stocks, bonds, and cash. (Glide path is the industry term for how the fund's strategic asset allocation shifts over an investor's life span.) Internally, however, nearly all firms use far more nuanced asset-class breakdowns. They know how much of a fund's assets will be allocated to much more specific asset classes, including large-cap U.S. stocks, small-cap U.S. stocks, foreign stocks, Treasury Inflation-Protected Securities, and so on. Some plan to dedicate assets to less common areas, including emerging markets, high-yield bonds, REITs, and commodities. As we've studied target-date funds, we've seen high-yield exposures ranging from 0% to 13% of assets and emerging-markets allocations from 0% to 10%, both of which can have a big impact on the fund's overall return and risk profile. To make informed investment decisions, investors need to know what's inside their target-date funds.

Some fund companies already provide the level of detail that we think investors need. At T. Rowe Price, for example, the firm's Web site cover page for the target-date funds provides tabs that show tables and pie charts to illustrate both the broad stock and fixed-income glide paths as well as detailed breakdowns within each major asset class. We think that the SEC should require all fund companies to follow T. Rowe's lead and provide detailed descriptions of the funds' glide paths.

2. A better discussion of risk.
It's one thing to see a fund's glide path, but it's also important to know why it was set up that way. Some funds are primarily concerned about longevity risk, or the risk that an investor will outlive his or her savings, so they tend to keep stock weightings high, even near or during retirement, so the assets have a better opportunity to keep growing. Among 2010 funds, we've seen strategic equity allocations from as low as 21% to as high as 79%.

Other firms see market risk--the risk of a sudden drop in the financial markets--as the greater threat. They tend to devote more to fixed-income allocations near retirement, in an attempt to preserve capital. When markets were riding strong in 2006, most target-date funds were primarily focused on longevity risk; in the wake of 2008's market collapse, the conversation has reversed, with market risk now getting all the buzz.

Investors--or the employers sponsoring their retirement savings plans--can decide based on their own circumstances whether longevity or market risk is the bigger threat to their retirement savings. But they can't make that call without understanding the funds' approaches. Industry regulators need to require funds to discuss the rationales behind their glide paths as part of the funds' prospectuses. Some companies, such as AllianceBernstein and T. Rowe Price, have been ahead of the curve in making available on their Web sites the research that goes into their glide paths, but more firms must be willing to take this step.

3. An explanation of the date in the funds' names.
SEC chairman Mary Schapiro has stated publicly that she's concerned that the target dates listed in fund names may be misleading to investors because they imply that investors are cashing out once they hit retirement. That may be overstating matters, but it's true that fund companies treat the so-called target date in different ways. Some continue to adjust the asset allocation so that it's more conservative (with less equity exposure and more fixed-income) until the investor is 10 or 15 years past the retirement date. This makes sense because an investor's risk profile continues to evolve even after he or she has retired. Other target-date series, however, keep the allocations static beyond the target date. This may be because the firm assumes that investors will move their money into an annuity or other investment program when they retire or because it aims to preserve capital.

The regulatory agencies need to push fund companies to better explain their approaches to investors here as well. Changing fund names alone probably won't do the trick. In their prospectuses, Web sites, and educational materials, target-date series need to give investors a crystal-clear picture of what sort of investing time frame they envision after retirement and how much risk they should expect to take along the way.

4. A record of deviations from strategic allocation.
A glide path is intended to be a long-term policy, based on fundamental research and extensive research and modeling. Some fund management teams, though, try to gain an edge on that long-term allocation by engaging in tactical allocation--usually involving bets on the shorter-term direction of one asset class versus another (for instance, high-yield bonds versus Treasuries).

If a target-date series does allow tactical allocation, investors should know that it may happen and know who on the team is responsible for making such calls. Then investors can evaluate whether those skippers are experienced and whether they've been successful in the past. Moreover, it's important to know how far the managers can deviate from the strategic weights. Fund companies may say that tactical allocation is a low-risk way to gain incremental increases in returns, but it's a highly specialized skill with the potential to go awry if a manager misreads a short-term trend. Management letters in the fund's annual and semiannual reports should explicitly address the types of moves and deviations they've been making.

5. A clear description of costs.
Investors should pay keen attention to the fees that they pay for a target-date fund because this may be their primary investment for 30, 40, even 50 years. Over that span, the compounded advantage of lower fees really adds up. We've been looking at target-date fund fees, and the lowest average family annual expense ratio among share classes with significant assets is 0.19%, and the highest is 1.4%. Those more-expensive funds prevent more than 1% of an investor's wealth from compounding annually, which could mean that an investor has tens of thousands of dollars less in retirement savings.

Unfortunately, fund companies have created a dizzying array of retirement share classes, whereby different employers may pay different expenses based on plan size, services offered, and other factors. If you're a retail investor, you may pay higher fees than investors in 401(k)s; retail-oriented series like Vanguard and Fidelity Freedom, however, keep things simple with one, attractively priced share class. Another point to note is that some fund companies have temporarily waived certain management or other fees to keep costs competitive, but whether those waivers will remain in force over the long term is an open question.

Of course, fund companies are already required to disclose fee information, but it's typically buried deep in the regulatory documents. In addition, 401(k) investors may have little clue of what share classes their employers have purchased. A simplified fee structure and better up-front disclosure would be a boon to the individual investor.

Peeling Back the Onion
All of these suggestions are really just a starting point to help shareholders be better owners of target-date funds. One target-date manager visiting Morningstar's offices likened the process of looking into target-date funds to peeling an onion: Every time you pare away one layer, you find another layer underneath. Target-date funds have been marketed to investors as a one-decision, lifetime investment. Yet these funds are far more complex than they appear on the surface, and the differences in structure, quality, and fees can have a great impact on investors' retirement savings plans.

This complexity is one of the reasons Morningstar has decided to develop research focused on target-date funds, which we'll release later this year. Fund companies have a lot of work to do to make target-date funds more transparent to investors. We hope that one outcome of the joint SEC-DOL hearing is a movement toward tougher disclosure requirements for target-date funds, and maybe better investor decisions as well.