Fund Misconceptions
By Rich Weiss and Nancy Pilotte
Sponsored Content – American Century Investments
Target-date funds (TDFs) have surged in popularity in retirement plans since being designated as qualified default investment alternatives (QDIAs) in 2007. According to some estimates, as many as three-quarters of plans with TDFs use these strategies as their default investment option. From the point of view of plan fiduciaries, TDFs are desirable because they improve overall participation rates, increase diversification across the plan, and are intended to address many of the classic shortfalls of individual investors. While there can be no guarantees that past performance will be repeated, two prominent studies show that TDFs provided better performance than investors who made their own selection and allocation decisions. From the point of view of plan participants, TDFs provide professional management, age-appropriate asset allocation, and rebalancing to predetermined targets in a single investment option.
However, despite their growing popularity, TDFs are still not entirely understood, facing a number of misconceptions. The first and perhaps most common misunderstanding relates to the suitability of “to” TDFs for investors after reaching the target date. A second common myth is that multi-manager TDFs are superior to single-provider products. Another is that higher average equity exposures mean greater returns and better wealth accumulation for participants over time. Finally, a fourth common misconception we will address is that passive investment strategies should be preferred to active investments in TDFs.
Myth #1: “To” target-date funds are not suitable investments after retirement
Significance of the Target Date
The target date or year within the fund name is the approximate date when the typical investor in the fund plans to start withdrawing money. The fund does not “mature” on the target date. Indeed, the typical TDF is designed to be held well past the retirement date, with the investor drawing down their balance gradually over time to fund their retirement needs.
But many investors incorrectly assume that because a given TDF is said to be managed “to”—as opposed to “through”—retirement that it cannot be held beyond the target date. The reality is that the distinction between “to” and “through” TDFs relate to the structure of their glide paths. Figure 1 is a graphic representation of hypothetical “to” and “through” retirement glide paths, highlighting crucial differences in asset allocation across the life of the portfolio.
Distinction between “To” and “Through” TDFs
TDFs in the “to” camp are managed with a glide path that reaches its most conservative asset allocation at the funds’ target date, and remains at a fixed allocation thereafter. It is important to understand that most TDFs with “to” glide paths are designed to fulfill post-retirement investment and income needs and are continually managed and monitored throughout the entire lifecycle. In many cases, this is achieved by folding the target-date fund into a retirement income portfolio within a few years after the target-date is reached.
TDFs in the “through” camp do not reach their most conservative asset allocation until after the target date. Relative to TDFs in the “to” camp, they tend to hold more equities in the five to 10 years before and after the maturity date, and to hold fewer equities in the later retirement years.
Figure 1: Hypothetical Glide Paths in Focus: Equity Exposure Over Time
Rationale for a “To” Retirement Glide Path: May Increase the Likelihood of a Fully-Funded Retirement Relative to “Through” Retirement Guide Path
We have detailed our research into the efficacy of “to” and “through” retirement glide paths in a number of papers, most notably Our Approach to the Target-Date Glide Path (2010) and What Do Five Years of History Teach Us about the Future? (2009). We will summarize that research briefly here. Our analysis along with a growing body of external and academic evidence suggest that target-date portfolios managed “to” rather than “through” retirement may maximize the likelihood of retirement success for plan participants without taking undue risk along the way. In effect, “to” TDFs strike a better balance between longevity risk—the risk that an investor will outlive her savings—and market risk—the volatility typically associated with equities.
With respect to longevity risk, “to” TDFs do a better job recognizing that risk exposure is highest on the day an investor retires. Their greater degree of diversification in the crucial years around retirement—when account balances are typically highest—significantly decreases the likelihood of an investor outliving their savings. Specifically, the “to” glide path reduced by half the likelihood that a retiree will run out of money too soon in one study. With respect to market risk, TDFs with “to” glide paths are more effective at reducing overall portfolio volatility—our research shows that a “through” glide path with the same average equity allocation as a “to” glide path has higher risk. Add it all up, and a “to” portfolio may increase the likelihood of a fully funded retirement for plan participants relative to a “through” retirement portfolio.
Myth #2: Multi-manager funds are superior because they select the best managers in each asset class
The argument: Proponents of a multi-manager, “open-architecture” approach claim the method is superior because it provides the flexibility to hire “best-in-breed” managers, and can also reduce manager overlap, creating diversification. On a related note, they would argue that this approach is superior to a proprietary, single-provider lineup, which may exhibit overlap to the extent that funds share a philosophy or process.
The reality: Several recent studies cast doubt on the premise underlying the “best-in-breed” argument, calling into question institutional investors’ ability to add excess returns through manager selection. In addition, portfolio oversight and management of the glide path for multi-manager products come with additional associated administrative duties and costs.
Best in [Past Performance] Class: Questionable Value to Institutional Asset Manager Selection
The desire to build and maintain a portfolio of “best-in-class” asset managers can lead to a pattern of hiring and firing managers based on recent performance—hiring high and firing low. Indeed, a growing body of academic research indicates that nobody wins who is hostage to the most recent return figures. A 2008 paper by Goyal and Whal in the Journal of Finance showed that even retirement plan sponsors—among the savviest institutional investors—tended to chase performance, typically hiring managers who had outperformed in prior years and firing those that lagged. Their study showed that the fired managers outperformed the newly hired manager in the trailing two years (the period covered in their analysis).
Similarly, a 2009 article in the Financial Analysts Journal demonstrated that products to which plan sponsors allocated money underperformed compared with products from which the assets were withdrawn. Significantly, the authors found that this effect persists over one-, three-, and five-year periods. What’s more, the analysis did not take into account transaction costs. As a result, the authors’ data actually understate the magnitude of the underperformance resulting from these manager selection decisions.
Information Advantage of Single Providers
There is a case to be made that proprietary investment companies may have a number of advantages with respect to evaluating the viability of an internal investment process or investment team. A single TDF provider naturally has access to essentially all information and data related to portfolio decision-making, personnel, and process for a constituent fund.
This points up a further advantage of single-source providers—the transparency to underlying funds allows quicker and better assessment of performance issues, style shifts, or other changes. So while proponents of a multi-manager approach argue for improved diversification, we believe that a single-source provider is uniquely well positioned to assess the overlap and risks to the total portfolio resulting from the positions that make up the underlying funds. Compare this scenario with a TDF comprised of a number of different asset managers, lacking transparency over underlying funds, and likely therefore more susceptible to unintended style or asset allocation drift.
In addition, we believe the efficiencies in communication, cash management, and fund operations likely keep transaction costs low for single-source providers. Indeed, the communication and management of cash flows and rebalancings are likely to be handled seamlessly and effectively when done in house. This can contribute to lower levels of uninvested cash, which tend to weigh on returns, as well as reduced transaction costs.
Dealing with Underperformance
Having greater transparency and insight into the causes of underperformance means the proprietary target-date manager can assess whether the strategy is merely out of favor or truly broken. This is an important distinction that we believe would be more difficult to reach for a consultant outside the firm. Certainly, dealing with underperforming strategies through a personnel or process change is, in the short term, less disruptive and less costly to target-date fund shareholders than exiting an underlying fund and incorporating a new investment option in the plan. Over the long term, fewer rapid-fire hiring and firing decisions can add up to better performance for the proprietary fund approach, which we believe addresses problems in a more disciplined, informed, and cost-effective manner.
Other Considerations
The reality is that creating a custom target-date solution will require a series of complex decisions around manager selection, asset allocation and glide path, rebalancing methodology, and range of offerings appropriate for the plan. This reality means a multi-manager approach will almost certainly require the retention of a consultant to help customize the plan’s offering, manage the glide path over time, and address administrative issues. These services come at a not insignificant cost; however, it is also true that there are likely savings that plans can realize by creating customized TDFs using investment options and strategies already established in the plan.
Myth #3: Higher equity exposure means higher returns and better wealth accumulation for participants
The argument: Proponents of greater equity exposure argue that longer lifespans, inadequate savings, and rapidly rising health care costs justify higher equity allocations. They would argue that this holds true even in the crucial 10 to 15 years around the target date and into retirement.
The reality: It is a classic mistake to assume that greater risk leads invariably to greater returns and higher account balances for participants. In a theoretical world, risk and return reside side by side, and moving out the spectrum on one dimension also leads you further out the spectrum on the other. So why not load the boat with equities, swing for the fences, and theoretically maximize total returns over time? Because we do not invest in a theoretical world, but in a very real world of retirement plan participants who can be highly sensitive to falling account balances, as well as highly end-point sensitive in terms of market risk as retirement nears. Indeed, what good is the most well thought out glide path if the passengers have long since bailed out? Further, there is no such thing as the “average investor” in reality. Each of us gets one and only one chance, or “path,” at retirement. Everyone’s unique investment path is critically dependent on their particular starting and ending points. Therefore, although equity returns may average 10% (plus or minus) annually over long time periods, most investors may realize significantly different equity returns at or around their unique retirement date.
Get Me to the Church on Time
It should be obvious that for virtually any investment strategy to work, the investor has to stick with it. But even though assumptions about investor behavior are crucial components of TDF construction, it is not clear that this lesson has been learned and applied across the industry. Many TDFs it seems have been designed for totally rational, long-term, utility-maximizing investors with the patience and also the savings cushion to ride out market volatility. We know from years of investment experience, however, that this hypothetical construct does not describe the average real-life TDF investor, who tends to be loss averse, particularly as retirement nears. Study after study in behavioral finance demonstrate this to be true. For a real-world example, we can look back to the financial crisis at the sizable net redemptions for TDFs at or near the target date— according to Morningstar, investors in 2000 to 2010 TDFs locked in losses averaging 22% in 2008.
Maximize Risk-Adjusted Return, Not Risk and Return
Given that context, let us bring the conversation back around to equities. If higher-volatility investments become increasingly difficult for investors to hold on to as they near the end of their savings accumulation phase, then aggressive TDF equity allocations must be of questionable benefit for retirement savers. Indeed, our research shows the opposite to be the case—by limiting equity exposure and increasing portfolio diversification, it may be possible to create a lower-volatility glide path that reduces the probability of an investor “bailing out” of their investments during market volatility and damaging their chances for success.
Rather than simply increase equity exposure and hypothetical returns, we find that TDFs should seek to maximize their risk-adjusted performance in order to improve return patterns over time. It is demonstrably true that above-average returns and below-average risks translate to better retirement outcomes for investors. Of course, it is also true that a balanced portfolio does not ensure against losses in any given year or period. But over time, the lower level of volatility and relative steadiness of the return pattern will provide for a higher compound, risk-adjusted return vis-à-vis other individual asset classes.
Additional Variables
Determining the “right” amount of equity exposure also requires some assumptions about the investors in the plan. These variables include time horizon (life expectancy), withdrawal rates, and future market returns. Of course, answers to these questions are likely to be as varied as the participants in the plan themselves. As a result, a fund’s glide path must be robust enough to account for a broad range of withdrawal assumptions, limiting market risk for those with large account balances, but also providing enough equity exposure to limit longevity risk for those with smaller balances.
The result of such an analysis is shown in Figure 2, which depicts the interaction effect of withdrawal rates and equity holdings on the likelihood of having enough money to fund retirement. At the top of the graphic we see that “good” savers (those whose account balances are large enough to require only a 4% annual withdrawal rate) ideally shouldn’t hold more than 20-30% in equity or risky assets post-retirement—they don’t require the extra return, and equity exposures beyond that level only serve to increase their market risk. On the other hand, “poorer” savers (those needing to withdraw a larger percentage of their nest egg each year) need at least 40-60% in equities to give them a potentially decent chance of succeeding in retirement, wherein “success” is defined as not running out of money. The thick orange line shows a compromise position for the average DC plan. The “sweet spot,” which we’ve highlighted, falls in a range between about 35% and 55% equities in retirement.
Figure 2: Optimizing Equity Exposure at Retirement
Myth #4: Passive investment strategies should be preferred to active investments in TDFs
The argument: Many plan sponsors are faced with the classic “active versus passive” management debate when it comes to choosing strategies for inclusion in a TDF. Proponents of passive strategies argue that the potential excess returns sought by active managers are offset by the comparatively higher fees they charge for their expertise. The result of this argument is a kind of blanket conclusion that active management doesn’t pay for itself and, therefore, passive management is a smarter solution.
The reality: We will briefly address the larger question of active versus passive management momentarily, but let us first concentrate on the question in terms of TDF construction and performance. We believe the distinction between “active and passive” investment strategies is essentially a false one in the TDF context—there can be no such thing as a passive TDF portfolio in the full sense of the word, when the portfolios’ composition, allocation, and glide path over time all involve active decisions. Indeed, these factors—portfolio construction, allocation, and glide path—are by far the most important determinants of TDF performance. Asset allocation decisions drive performance to an extent and magnitude far out of line with the potential handful of basis points investors can save in terms of management fees by using passive investment strategies.
With respect to the larger question of active versus passive portfolios, while we are unlikely to resolve that debate here, we think it is safe to say that the relative performance of active versus passive investments is highly timeframe dependent. There are historical periods, depending upon your selection of start and end dates, when passive investing strategies beat active investment strategies. And there are other periods when active management strategies clearly outperform. In addition, it pays to remember that there is a wide dispersion of returns among active managers, which is why all the effort that goes into manager selection is worthwhile—managers that can outperform their benchmarks over time are well worth their higher expense ratios.
This brings up another crucial point. In a challenging investment climate when many practitioners expect more modest rates of return going forward, the potential to realize positive alpha is tremendously valuable. By comparison, choosing a passive strategy equates to built-in underperformance equal to at least the cost of the fund. Of course, a TDF provider may decide that this assurance of modest underperformance has merit compared with a higher fee and the risk of wider underperformance by an active manager. But it is this desire for positive alpha strategies that explains why the defined benefit world generally favors carefully selected active managers.
Material presented has been derived from industry sources considered to be reliable, but their accuracy and completeness cannot be guaranteed. Past performance is no guarantee of future results. This information is not intended to serve as investment advice.
Opinions expressed are those of Rich Weiss and Nancy Pilotte and are no guarantee of the future performance of any American Century Investments portfolio. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.
©2011 American Century Proprietary Holdings, Inc. All rights reserved.
