Building the Nest

Since the Pension Protection Act ("PPA") was signed into law in 2006, Target Date Funds have experienced burgeoning asset flows, even when many segments of the mutual fund industry's gathering efforts have been quite anemic. One of the main results of the PPA was to permit Target Date Funds to serve as the "default investment" for 401(k) and defined contribution plans, therefore the growth of these "auto-piloted" investments should come as no surprise.

For those needing a quick conceptual cajole, Target Date Funds provide a bundled, asset allocation vehicle based on the year an individual believes they will retire. In 2009, according to the Deputy Secretary of the Dept. of Labor Seth Harris, Target Date Funds "were designed to be simple, long-term investment vehicles for individuals with a specific retirement date in mind."1 For example, if I enroll Company ABC's 401(k), I can allocate 401(k) contributions to "Fund Co. Target Date 2040" (because that's the date I think I'll retire). By making this investment choice I have delegated, to the portfolio manager of the Target Date 2040 Fund, one of the greatest portfolio challenges I'm presented as a long term investor: dynamically changing asset allocation to reflect life changes from income accumulation to income distribution.

In general a nascent laborer / prudent saver with decades left until retirement should allocate towards a more aggressive, equity-driven portfolio. As the laborer gets closer to retirement, the accumulation of wealth will transition to distribution of wealth, during which time (arguably) a less volatile, income-centric investment allocation is most appropriate.

Managing the asset allocation change to reflect life transition is far from easy. In 2007, before the financial crisis, 30% of workers thought they would retire after the age of 65 -- that number has now grown to nearly 40%.2 One could certainly make the case that the 33% increase of "deferred retirees" is in some way attributable to the mismanagement of this life transition.

When Six & Half Dozen are Not the Same

Managing the risk of life transition is a highly personal choice, whether you choose a Target Date Fund, a financial advisor, or squarely place the burden on your own shoulders. However, understanding more of what a Target Date Fund will, and will not do, can be highly valuable when delegating this responsibility. We therefore briefly delve into the challenges and fine print an investor should be wary of when leveraging this "all in one" bundled, investment solution.

Target Date Funds are described by two things: the name of the Mutual Fund Company charged with managing the assets and the "target date" of the fund (as mentioned, when the investor "believes retirement will begin"). Furthermore, an investor would hope that two target funds differing only by fund company would experience very similar risk and return profiles. Homogeneity of risk and return profile would ensure an investor is not penalized because her company chooses to work with XYZ Mutual Fund Company, while her spouse's company retirement plan is with ABC Mutual Fund Company. Unfortunately, studies have found a high degree of disparity between Target Funds Sharing the same target date.3 In fact, if an investor randomly chose a 2010 Target Date Fund between November 2007 and February 2009, they could have seen a 15% annualized loss or a 40% annualized loss, depending on the chosen fund.4

Nest Egg on Your Face

With high spreads of risk / return profiles between same date funds, the logical question to ask is, "how will allocation decisions by same date fund managers differ during different market environments?" Answers to this question would provide the investor / financial advisor with valuable insight regarding fund risk exposures. Furthermore, in the event the investor has other assets, allocation decisions can incorporate the likely changes that will occur within the specified Target Date Fund.

To find the answer to these questions we sifted through Fund Prospectuses, Statements of Additional Information, and even Fund Manager's Quarterly Commentaries. As experts in Rules-Based Strategy Construction, our inhibitions around these "all-in-one solutions" would have been quelled if these fund documents included statements like:

If inflationary expectations exceed the threshold of 'y%', then the fund will deviate, at most by 'z' percentage points, from its allowable tolerance of tactical shift towards inflationary protected vehicles such as TIPS and floating rate debt."

Given market declines in excess of 'x%,' tactical allocations no greater than 'y%' will go towards 'risk-off' assets such as short-term treasuries.

If domestic equity earnings persistently remain below foreign earnings for an excess of 'z' years, the fund may deviate from its target allocation towards domestic equity by no more than 'y' percentage points of its investment policy allocation.

Statements such as these would provide investors / financial advisors the ability to roughly construct portfolio allocations in concert with Target Date Funds, instead of post facto. Unfortunately, the lengthy documents of Target Date Funds we examined spent most of their time detailing general risks of investing, while providing a marginal degree of tactical shift allowed to the manager. Sadly, the tactical allowance was neither accompanied by the impetus that would promote such a tactical shift, nor the train of logic the portfolio manager uses when determining the amount of deviation from the fund's investment policy.

A Cuckoo in the Nest of Investment Options?

Although Target Date Funds address some of the more significant allocation risks faced by investors, they also leave a lot of unanswered questions that create a veil of obscurity as to how the fund will perform in different market environments -- much like a Black Box. Determining whether a Target Date Fund should be chosen from the available investment options within your 401(k) is clearly a personal choice, but here are some steps you can take to make sure your decision is informed:

  1. Look up the specific Fund Company in your defined contribution plan in Morningstar's Target-Date Series Research Paper published every year. There you will find valuable information regarding fund expense ratios, stability measures (of Glide Path), Performance, and a host of other necessary statistics.
  2. Know your Glide Path: The glide path of every Target Date Fund is published in the prospectus, detailing how quickly the allocation is going to shift from an investment goal of aggressive growth to capital protection. Even though the manager is allotted a certain amount of tactical shift, the specific glide path will provide a decent perspective of how the fund allocation will change over time, and how quickly.
  3. Keep a Short Leash… or at Least Know how Long your Leash Is: The amount of allowable tactical shift is also published in the Target Date Fund Prospectus. Therefore, you may not be able to determine exactly how a manager is going to allocate in given market environments, but you can know how much he's allowed to allocate.
  4. More than One Way to Lay a Nest Egg: In most defined contribution plans, if you're provided a Target Date Fund as an investment option, you're likely provided other "bundled solutions" like balanced funds. Vallapuzha Sandhya found that in general, Target Date Funds underperformed Balanced Funds5 for a number of different reasons. Using a Balanced Fund provides increased transparency and is a lot easier to build an asset allocation around, so consider Balanced Funds to catch a majority of income tax deferred savings, and then build around that depending where you are in the stages of life cycle planning.
  5. Are you a "To" or "Through" Kinda Bird? As if Target Date Funds weren't already confusing enough, one further distinction is whether the date portion of the target date is a "to" date or a "through" date, where the asset allocation ceases to further evolve or continues, respectively.

No investment decision should be taken lightly. However, the default investment that will receive the majority, if not all, of a long term investor's deferred income contributions should receive particular scrutiny. The SEC's approval of Target Date Funds as the default investment for defined contribution plans was driven by many decisions, one of which was investor's tendency to allocate the entirety of their company sponsored investments towards money market funds. However, it should be noted that Target Date Funds are inherently obscure, provide little detail to clarify how allocations will change, or fail to change as market environments evolve, and exhibit high degrees of heterogeneity, often times in the form of downside losses. We are certainly not claiming that the Black Box option of Target Date Funds is worse than a money market fund for a long term investor; however there is a high degree of transparency and understanding of behavior of money market funds during any type of market environment, of which for Target Date Funds the same cannot be said.


  1. DOL and SEC Joint Public Hearing on TDFs and Other Similar Investment Options: June 18, 2009.
  2. http://money.usnews.com/money/blogs/planning-to-retire/2012/05/08/the-new-ideal-retirement-age-67
  3. Balduzzi, Pierluigi and Reuter, Jonathan, Heterogeneity in Target-Date Funds and the Pension Protection Act of 2006 (February 22, 2012).
  4. Colon, James A., CFA. “The Problem with Target-Date Fund Glide Paths.” The Problem with Target-Date Fund Glide Paths. N.p., n.d. Web. 21 Dec. 2012.
  5. Sandhya, Vallapuzha, Agency Problems in Target-Date Funds (March 14, 2010).

Benjamin is a Managing Director in Newfound’s Product Development and Quantitative Strategies group, where he is responsible for the ongoing research and development of new intellectual property and strategies. Specifically, Benjamin’s focus is in the area of exploring model applications to fundamental, economic and systemic market variables. Drawing on his years of experience in the financial services industry, he helps to ensure that Newfound’s products and messaging effectively meet the needs of investors and portfolio managers. He also plays a critical role in developing new business and client relationships.