A New Approach to TDFs (and Why the Old One Doesn’t Work)

(November 21, 2013) — Target-date funds are fundamentally flawed and are failing defined contribution retirees, according to a paper by Research Affiliates, who have created a new model for the industry to try out.

The objectives of a traditional “glidepath” approach, namely maximising the real value of nest eggs and minimising uncertainty around prospective retirement income, are actually not met, the authors said and tested a range of alternatives.

“First, rebalancing to a static mix beats a gradual shift to bonds (or equities for that matter, because the solutions are not linked to expected market environments),” the paper began. “Second, adjusting the risk profile within stock and bond portfolios rather than across asset classes reins in risk more constructively than the classic glidepath solutions. Third, incorporating valuation-indifferent equity strategies improves the historical performance of the solutions relative to alternatives built using cap-weighted indexes.”

The paper showed the authors’ working on these points and offered an argument for more time to be spent on constructing funds. It argued that the basic idea of younger workers buying equities for their pension portfolio then moving into bonds as retirement approaches had been proved to be a flawed idea, yet many in the industry have bought—and continue to buy into—the idea.

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“Our alternatives are deliberately simple, so that they illustrate our points vis-à-vis existing target-date alternatives; we acknowledge (and believe) that skilled active managers can achieve superior results, particularly when they customise these solutions for an individual investor.”

The authors called on the asset management industry to do more to create strategies that help the end investor attain their retirement income goals and to think outside the box. Clients need help in realising what level of income would be attainable and framing their objectives, the authors added.

Finally, the industry must realise that it needs to question current approaches when empirical evidence is produced to disprove their efficacy.

“Our illustrative strategies are no recipe for replacing the classic glidepath strategies; they merely illustrate how easy it is to improve our clients’ prospective retirement income and wealth.”

The authors said a more sophisticated solution might add a whole spectrum of additional asset classes—outside the traditional equities and bonds—that could offer higher yields, growth, or both, than the current glidepath portfolio.

The authors concluded: “These represent avenues for future research, which we invite others to join us in pursuing.”

To read the full paper, click here.

A study found the shift from GAAP to mark-to-market accounting practices has no significant effect on corporate finances and stakeholders’ functions.

(November 20, 2013) — Changes to mark-to-market valuations of defined benefit pension plans’ liabilities have a negligible impact on corporate finances, despite sponsors’ concerns, according to SEI research.

These new accounting practices—valuing assets on their current market prices—get rid of “smoothing methods” that aimed to decrease year-to-year volatility. Pensions must recognize gains or losses into their balance sheets as they occur, which allows for more transparent and accurate view of plans’ funding statuses. In theory, this change rendered corporate finances more vulnerable to pension funding volatility and thus negative earnings, the report found.

However, SEI's study of 23 major US companies that implemented mark-to-market accounting over the past two years found the shift had minimal impact on the functions of investors, analysts, internal management, and ratings agencies.

The report concluded that with “no cash implications,” investors also had little to no response to the change—share prices remained untouched.

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The report also said that financial analysts had already been applied mark-to-market accounting to more accurately compare performance between companies. Earnings calls were also largely absent of direct concerns and criticisms of the change from generally accepted accounting principles (GAAP) to mark-to-market.

“In many analyst reports, the mark-to-market adjustment is out of annual earnings forecasts, for comparison purposes to historical results,” the report said.

Corporate management even enjoyed the methodology change, SEI said. It relished removing drags on earnings, reaping in better earnings per share as it avoided impact from past poor performance.

The study also revealed that ratings agencies such as S&P, Moody’s, and Fitch had already been using mark-to-market accounting—unwinding the GAAP accounting treatment. Even still, "pension-related factors" have a limited effect on credit ratings, SEI found.

“While significant changes to the funded status may limit upgrades, it would be unusual that this would lead directly to a downgrade on its own,” the report said.

This observation, however, might not apply to US public pensions.

In April, Moody’s decided to overhaul its valuation methodology for public plans, employing mark-to-market accounting to determine their liabilities—holding them to a higher standard. The result? A much lower average discount rate—5.5% from the industry average of 7% to 8%— and significantly larger total liabilities than those reported using GAAP.

These new calculations revealed some US public pensions are serious underfunded than previously thought, which impacted credit ratings. Illinois was recently downgraded by Moody’s—to A3 from A2—for its $100 billion pension debt crisis.

“I think the impact of Moody’s methodology change is really important to understand,” Dave Wilson, managing director and head of the customized strategies group at Cutwater Asset Management, told aiCIO last month. “Their ratings have a big impact on municipal financing levels, and they will punish you if your pension plan is too underfunded.”

Six state pensions, including Illinois, have already suffered a downgrade.

Thomas Harvey, SEI’s director of advice, maintains the change to mark-to-market may better service pension plans: “Plan sponsors that might have previously been hesitant about such a change should potentially re-evaluate their pension accounting options.”