A Smoother Ride For Target-Date Funds

December 27, 2010

No matter how diversified the portfolio, risk and reward aren’t linear.

 

The invention of the autopilot was a critical advance in aviation history. Why? As flights got longer, pilots suffered from fatigue and made errors. They needed a stabilizer to keep the plane on course and adjust for changing conditions. When 21-year-old inventor Lawrence Sperry demonstrated his gyroscope-equipped autopilot at a 1914 Paris air safety show—both he and the plane’s mechanic actually walked onto the plane’s wings in mid-air, leaving no one in the cockpit—the spectators were stunned. Sperry became an international celebrity overnight.

In our industry, the target-date fund is intended to provide an autopilot for defined contribution participants—most of whom aren’t any more qualified to pilot their investments than Wile E. Coyote is to jump into the cockpit of a 747. Target-date funds are simple investment solutions whose asset mix becomes more conservative and income oriented as the target date approaches. In theory, that ratcheting down of exposure to risky asset classes should be a good thing. In practice, as the last 10 years has illustrated, risk is not linearly rewarded. The “glide paths” of target-date funds assume constant risk premia from equities and other asset classes.

In this issue we explore another path utilizing the Fundamental Index® approach and find its inherent contra-trading produces a far better result. Furthermore, this approach is simple and inexpensive, two critical components of an effective 401(k) solution. In addition, we review how a simple tactical asset allocation approach would generate an even bigger retirement kitty.

Risk Premiums Are Not Constant

Considerable evidence exists that 401(k) investors do not make good investment decisions in their retirement plans. One study (by Munnell et al.) found that 401(k) plans experienced a 1% shortfall relative to defined benefit plans from 1988–2004 “due to poor timing and other investment mistakes.” The study further explained that 401(k) participants on average make sensible investment choices, but on an individual basis are poorly diversified.1 Other research found that employees tend to use a small number of investment options—typically three or four—and offering too many choices can cause “information overload” and can reduce participation and contribution rates.2

Target-date funds are designed to address these issues. They offer a pre-diversified, “one-stop shop” that adjusts asset allocation over time as retirement draws nearer. Equity bets—by far the largest risk source—are diversified by style (growth and value), size (large and small), and geography (U.S., developed ex-U.S., and emerging markets). But they miss the boat in one key area—they fail to adjust to changing market conditions. At some points, investors are amply rewarded for placing their chips on stocks (the forward-looking equity risk premium is large); at other times—usually when markets are in a boom phase and stocks are over-valued—investors receive little reward for taking sizeable equity exposure (the equity risk premium is small).

How volatile is the equity risk premium? Figure 1 illustrates how the excess return of stocks over bonds changes during market cycles. The same is true within equity markets: During some periods, value stocks are priced to deliver a substantial premium while other stretches show value offering little or no premium. A similar effect occurs in size and geographic orientation. One of the key benefits of target-date funds—their simple, formulaic approach to asset allocation—has turned out to be the source of their biggest problems. If market conditions are not factored into the decision on asset allocation, investors could own too much of an asset class at peak valuations—a likely precursor to future underperformance. We saw evidence of this in 2007–2008 when some funds held very high equity exposures despite very high valuations and low dividend yields, shrinking the nest eggs of those close to retirement age when stock markets plummeted. These same strategies missed a spectacular rebalancing opportunity in early 2009.3

Five-Year Realized Equity Risk Premium

 

 

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