Are Target Date Funds The Answer?

English: Risk-Return of Possible Portfolios
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Target date funds have become popular with 401(k) plans (defined contribution) because of their simplicity. Based on the participant’s age a projected retirement date is determined, for example a 37 year old will retire at 65 in 2040. Therefore this participant would choose the 2040 portfolio and as the participant ages the portfolio would automatically become more conservative. Problems arose during the ‘Great Recession’ participants in the 2010 portfolios thought they were very conservative and lost 38%. Hardly the conservative choice participants expected.  It turns out all target date funds are not created equal.

An alternative has been gaining momentum. Professionally managed risk adjusted globally diversified portfolios. These portfolios have a defined expected return and expected volatility (risk), there will be no surprises. These portfolios, like target date funds, provide a pension fund like investment without the uncertain level of risk. Managed portfolios provide a level of clarity and defined risk and volatility.

The Pension Protection Act of 2006 allows plan sponsors to utilize the Qualified Default Investment Alternative QDIA. This Act allows the participant to be automatically put into the appropriate portfolio based on their age. The participant is moved automatically, to a more conservative portfolio as the participant ages.

In this plan design the participant has three options:

  1. Remain in the default portfolio
  2. After an assessment determine the proper level of risk and adjust the portfolio either more conservative or more aggressive.
  3. Opt out of the model portfolios and choose their own fund mix.

Combine this design with the plan sponsor hiring an ERISA 3(38) Investment Manager and the plan sponsor will realize minimized fiduciary risk and a quality retirement plan for their employees.

A number of studies have determined that most plan participants prefer the model portfolios (QDIA) to choosing their own fund mix. After experiencing the extensive volatility participants are looking for guidance from their employers.

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Dirty Tricks Brokers Use to Get Your Business

There really is no great secret on successful investing for long

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term goals. You do not have to know everything about investing to succeed, but you do need to know the right things. There is an academic method to developing a diversified portfolio, custom fit to each individuals situation. This goes against the Wall Street model that strives to keep investors in fear that they need Wall Street to guide them in ever changing directions.

Misleading tiltThere is significant research supporting the value of tilting the stock portion of a portfolio towards small and value stocks. Tilting towards these riskier asset classes can increase expected returns, albeit with increased risk. However, there are periods of time when large and growth stocks outperform small and value. For example, in 2011, large cap stocks outperformed small cap stocks.

By tilting the stock portion of a portfolio towards the asset class that outperformed in the past year or two, advisers can make it appear they have the ability to increase returns in the future. Don’t be fooled. If your adviser is recommending a tilt towards any asset class, ask to see long term data supporting this recommendation.

Using long term and lower quality bonds

By using long term (maturity dates more than 5 years) bonds, and bonds with ratings below investment grade, brokers and advisers can make it appear they are generating higher returns. Many investors don’t understand these returns come with higher risk. Historically, according to research done by Dimensional Fund Advisors, long term bonds are more volatile than shorter term bonds, but have not provided consistently greater returns. The same research indicated that bonds lower in credit quality have earned higher returns, but there is a greater risk of default.

You would be better advised to limit your bond holdings to maturities of five years or less and to insist that all of these holdings be rated investment grade or higher. You can increase your expected return (and your risk) by allocating a greater portion of your portfolio to stocks, assuming that would be suitable for you.

Using short term returns

Short term data can be extremely misleading. Some brokers and advisers cherry pick funds for inclusion in a recommended portfolio that have impressive three year returns. The implied message is that these funds are likely to outperform in the future. You can find a discussion of the benefit of longer term data here.

You should insist on seeing at least a 10-year history of returns and preferably longer.

There’s an old Chinese Proverb that says: “If you must play, decide upon three things at the start: the rules of the game, the stakes, and the quitting time.”

You now know some of the rules of the game.

This is how most brokers compete and it does not involve the truth.

Please comment or call to discuss.

  • Their Confidence Is Killing Your Returns II (
  • Diverisification Is Your Buddy (
  • Asset Allocation Basics (
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The Big Flaw in 401(k) Reform

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For the 401(k) plan of the future to succeed we should offer professionally managed for all employees. Rather than plan participants choosing their own investment mix of funds a pensiion fund tyoe investment vehicle will work best. Individuals are ill prepared to manage their own retirement accounts.

Here’s what real reform would look like:

  • Every plan should be required to have a minimum of five risk adjusted, globally diversified portfolios (ranging from conservative to aggressive), consisting solely of low management fee stock and bond index funds. Employees would take a short risk capacity survey and select the portfolio suitable for them;
  • Investment advisers to 401(k) plans should be required to state in writing that they are “3(38) ERISA investment fiduciaries”, which means they can have no conflicts of interest. They would accept 100% of the liability for the selection and monitoring of the investment options in the plan. These advisers would be required to provide investment advice to all participants to be sure they have chosen a portfolio suitable for their investment objectives and capacity for risk.

These simple reforms would radically improve the expected returns of plan participants.

The underlying fallacy in current efforts at 401(k) plan reform is that employees are capable of making intelligent investment choices when presented with a dizzying array of mostly poor investment options. I recently spent time with a group of nurse anesthetists whose plan we advise. It never occurred to me to ask them to give me ten needles and five choices of anesthesia (some good and some dangerous) and let me handle their next patient.

Why do we assume employees can be skilled investment advisers? We need reform that makes the process of making investment selections in 401(k) plans foolproof. Current reform just doesn’t cut it.

Plan sponsors would benefit from these two proposals because this mirrors the old pension plan. The participants in their plan would improve results and reduce anxiety.

Please comment or call to discuss how this would affect your company no matter the size.

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