Is Your Target-Date Fund's Glide Path Unstable?

The SEC's recent investor survey reaffirmed that investors misunderstand target-date funds in many ways: They tend to think they are safer than they really are, for instance, and they imagine there are few differences in the design or risk profile among target-date series, when in fact those differences can be dramatic.

Another little-recognized aspect of target-date funds is their glide paths--the way an investor's asset allocation changes over time--may change. This is not the expected change in allocations from year to year as stocks decline and bonds increase; rather it's when the entire glide path itself shifts up or down, so an investor who is 25 years old today does not have the same stock allocation as a 25 year old did five years ago.

Researchers from Morningstar Ibbotson Associates identified this phenomenon and assigned a metric to it, called the Glide Path Stability Score, or GPSS. In the Morningstar Target-Date Series 2012 Industry Survey, published last week, we elaborate on the GPSS and provide some color around the scores associated with different target-date series. The notion of glide path stability offers a compelling new perspective on target-date funds for consultants, researchers, plan providers, plan sponsors, and investors. It quantifies an often opaque aspect of target-date series; namely, that series architects may alter their glide paths over time.

The table below shows the GPSS for all target-date series receiving analyst ratings from Morningstar as of Dec. 31, 2010, the date as of which Ibbotson ran its study. (It plans to update those numbers as of year-end 2011 later this year.) The GPSS is shown for both the three-year period and since the series' inception. It's not necessary to get into the weeds of how the GPSS is calculated, but a basic understanding will be helpful.

  - source: Morningstar Analysts

In essence, the GPSS shows the absolute percentage change in equity exposure that a glide path has experienced on an annualized basis, averaged across all the funds in the glide path. Thus, for example, a target-date series that has a GPSS of around 3.0 (which is the average for our since-inception sample) over a three-year period has shifted its equity allocation by 3 percentage points per year, or 9 percentage points total.  A shift of this magnitude (and extrapolated over more years, even higher) surely raises some questions for investors.

A glide path change is not inherently bad, however. Ibbotson researchers suggest that GPSS scores below 1.5 should be considered stable, between 1.5 and 3.0 somewhat unstable, and scores beyond 3.0 are progressively more unstable. Beyond the numbers, though, what's more important is the rationale behind glide-path changes. If alterations are extreme or frequent or poorly communicated to investors that would be cause for concern. Large and frequent changes may suggest asset allocators lack methodological rigor or commitment. They may also cause investors to end up in target-date funds that, 20 or 30 years down the road, look nothing like the investments they initially purchased. Weak disclosure only exacerbates this problem. On the other hand, a single well-researched and fully disclosed glide path shift isn't as concerning, even if it was large.

Smooth Riders
Specific series' GPSS scores can help investors understand the factors contributing to relative glide path stability. Despite a relatively volatile period for target-date funds, some firms have shown a remarkable ability to stay the course. T. Rowe Price Retirement, for example, one of the largest and oldest and most consistent series, has a three-year GPSS of 0.81 percentage points and a since-inception rate of 1.02%. T. Rowe Price maintains one of the most aggressive glide paths in the industry but continually shares its evidence and rationale in support of its approach. It made no changes after 2008.

BlackRock Lifepath and Vanguard Target Retirement also exhibit low GPSS, particularly over the three-year period. Vanguard, a passively managed series that adds new asset classes only cautiously, has been successful with little disruption to its glide path (GPSS of 0.52 percentage points for the three-year and 2.62 since inception). BlackRock (GPSS of 1.30 since inception), via its BGI predecessor, is the oldest target-date series, though the data here only starts in 2004. BlackRock uses index and actively managed components, and its well-regarded asset-allocation group has made few glide path changes. Actively managed American Century Livestrong also has had a stable glide path, with a GPSS of 1.53 percentage points since its 2005 inception.

Bumpier Paths
Several series have shown high GPSS levels that provoke questions. Some have reasonable answers. Putnam RetirementReady shows one of the higher ranges, with a GPSS of 6.06 % over the past three years and 4.08% since inception. Putnam made a  significant structural shift in 2009 when it moved from a traditional fund-of-funds approach to using a mix of allocation and absolute-return strategies within the series. These newer strategies can make use of derivatives or shift tactically in the short term.

ING Solution also has shown significant shifts, with an average change of 3.94% over the past three years and 6.05% since its 2005 inception, the highest since-inception GPSS in the sample. Much of this instability derives from a change made early in the series' history: The series swapped a conservative glide path for a more equity-heavy approach. Changes have been less pronounced since then.

Wells Fargo DJ Retirement's since-inception GPSS of 4.62 percentage points also traces to a significant 2006 glide path change made when it switched subadvisors. That shift led Wells Fargo to offer one of the most conservative "to" glide paths in the industry. Since then, the glide path has been more stable with a 1.39% three-year GPSS.

A number of large, successful series hover close to the mean, such as Fidelity Freedom (3.32%) American Funds (2.94%), and JPMorgan SmartRetirement (3.50%). In these cases, there's no major cause for concern. Though Fidelity's glide path has changed significantly on an absolute basis since the series' inception, Fidelity was a pioneer in the space, and asset-allocation philosophies have evolved.

What steps should you take if your target-date fund has an inflated GPSS? There's no need to panic, but you should ask some pointed questions. Has the fund company based its glide path changes on a compelling, supportable rationale, and has it clearly communicated those changes to investors and other stakeholders? Or have its changes been erratic, market-driven, and/or poorly (or not at all) communicated? And do such changes ultimately benefit fundholders by producing better risk-adjusted returns? If the answers aren't satisfactory, it might be time to start looking for better, more consistent options.