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A crack marksman visits a village only to find bull’s-eyes on every wall—with the centers perfectly shot out. He asks who is such a perfect shot. He is directed to a scruffy looking country bumpkin. The marksman offers the bumpkin a substantial amount of money if he can tell him how he became such a good shot. The bumpkin takes the money and tells him the answer is simple: He shot first and then painted the bull’s eye around the shot.
The same could be said about target date funds (TDFs).
For a given target date, typically restricted to years ending in 0 or 5, the standard fund can be characterized by a starting allocation to a high-level asset allocation (stocks, bonds, and cash); a glide path (or a predetermined rate of reallocation between equity and fixed income/cash); and a desired allocation at the retirement date. The fund seeks, through these three parameters, to achieve an average allocation that is also pre-specified. Typically, the assumed retirement age is 65.
To quote a target date fund brochure: “Simplicity: Pick one fund—your decision’s done; Confidence: Each fund is professionally managed and diversified; Convenience: Each fund is automatically adjusted over time.” The question one has to ask is what is meant by “your decision’s done?” What constitutes professional management? And what is the value of “automatic adjustment?” These TDF products have spread like wildfire, especially since the Department of Labor (DoL) provided them with Qualified Default Investment Alternative (QDIA) status and even the World Bank is suggesting this approach for countries that are seeking to reform previously flawed reforms. Newer flavors from the simple glide-path approach are cropping up every day with more asset classes and the ability for large pension funds to access their preferred active managers.
There are four main beefs I have with these products:
First, the DoL blessing these products is like allowing someone to participate in an F-1 car race because they use a particular technique to change gears. The goal of a good pension product is to ensure that participants get a good pension at retirement; it should not be some silly rebalancing that adds more to fixed income because one happens to celebrate a birthday. These products are based on flawed academic models that assume that fixed income is the safe asset; with debt/GDP ratios rising globally, a simple formula to increase bonds as we all age may land us in a soup. The focus for QDIA status should be on the replacement rate earned by the participant—not on the asset allocation.
Second, this form of rebalancing is a tactical bet and there are better and more intelligent ways to do this as shown in the recent aiCIO article on the San Bernardino County Employees’ Retirement Association. If rates keep sinking across the globe and debt levels keep rising, adding to fixed income is like pouring gas on a flame.
Third, the original versions of these products could have been offered for a song (well below the 50 to 80 basis points charged per year), since the asset class exposure and rebalancing could have been achieved with futures contracts for a few basis points. Instead vendors choose more expensive internal asset class funds or passive funds, and 50 to 80 basis points of fees compounds meaningfully over 40 years to reduce final pensions.
Finally, to use economic jargon, the risk bearer (the participant) and the risk taker (the asset manager) have a very imperfect contract. To paraphrase Dennis Hopper, “bad things are going to happen, man, bad things.”
In making a single selection of a fund based on one’s retirement date, the participant delegates many decisions to the TDF vendor yet bears all the risks if the vendor messes up. These decisions include the asset allocation over time (formal glide path), rebalancing around the glide path, detailed sub-asset allocation, choice of funds, choice of benchmark, currency risk, and overall risk management. If the vendor is incompetent in any or all of these areas—and many participants will discover this incompetence only 25 years into the future—they have already paid rich fees for the privilege of being left in retirement penury. A better alignment of interests would be to have very marginal fees paid along the way and the bulk of the fees paid at retirement if the fund delivers some minimum corpus to the participants. In short, the party least capable of bearing this risk is also the one paying a substantial fee for the joy of bearing it, and given the average knowledge of pension finance among participants (including people like me who have spent more than a decade worrying about pension issues), Dennis Hopper just might be right.
Dr. Arun Muralidhar is Chairman of Mcube Investment Technologies LLC (www.mcubeit.com), and CIO of AlphaEngine Global Investment Solutions (AEGIS).