By Guest Contributor Emmet Martin | Novus Advisors
Diversify the portfolio, and give participants the information they need to keep out of trouble
The use and prevalence of target date mutual funds has skyrocketed since their designation as a qualified default investment alternative (QDIA) under the Pension Protection Act of 2006. After all, the concept makes sense: Choose a date (presumably the year that you will retire) and the mutual fund company will manage your assets so as to get more and more conservative as that date approaches. The concept is that while you have more time to retirement, you have more time for recovery (i.e., more volatility).
As much sense as this may seem to make, one doesn’t need to peel the onion far to expose a few flaws that can negatively affect the participants as well as the fiduciaries of qualified retirement plans.
Target date funds generally include a year in their names. The year indicates something, but the Department of Labor and the Securities and Exchange Commission have yet to dictate a standard as to what the year actually means. While some asset managers will set their glide path to plan for retirement at the target date, others will manage the assets for retirement through the target date.
Neither is necessarily right or wrong; however, when planning your retirement future, it’s a pretty important distinction. As a fiduciary (i.e. plan sponsor), this could become problematic as the litigious nature of our society seemingly grows ever more intense.
Target date funds are not tactical in nature. In general, they’re strategically created based upon modern portfolio theory – a concept that each type of security has a specific level of risk and that an efficient portfolio can be built utilizing over 100 years of market data combined with an optimizer (computer simulation). As time passes, more assets are taken from equities (stocks) and placed into fixed income (bonds). The speed and frequency by which this transformation takes place depends upon the glide path as dictated by the mutual fund company.
Rising interest rates are generally considered the largest risk to the value of bonds. It’s generally understood that when interest rates go up, the values of bonds go down. As time moves forward there is no doubt that the glide path movements of target date funds (all of them) will continue to purchase more and more bonds into the portfolios of their participants.
This should lead participants to ask these questions:
- Is the next big move in interest rates going to be up or down? (Hint: interest rates are currently at all-time lows.)
- Why would I want my portfolio to become more heavily laden with bonds regardless of the current interest rate environment?
Plan sponsors should also consider their potential fiduciary status as they ultimately have responsibility and liability as to the construction of their qualified plan platform.
The Department of Labor’s Employee Benefits Security Administration (EBSA) and the Securities and Exchange Commission (SEC) have released some guidance as to how plan sponsors and fiduciaries should consider target date funds. This guidance has been very general in nature; the consensus is that the industry is a work in progress that will continue to evolve and that communication between sponsors and participants should be improved.
Although the vague nature of this guidance indicates some leeway, a plan fiduciary should never assume justification based upon common sense – especially when dealing with governmental regulators.
The best solution for all parties seems to be to diversify the portfolio options: Add some non-correlated assets (not affected by the stock or bond market) such as natural resources, precious metals or REITs. Add some tactical investment funds – risk-based models with the freedom to actually go to cash in a bad market instead of systematically plodding along a glide path. Finally, make sure that your participants are getting the information that they need to be successful and to keep you (the plan sponsor) out of trouble.
[break]
Emmet Martin of Novus Advisors is in his 24th year in the financial services industry and has vast experience in many different facets of asset management. Martin attained his designation as a Certified Financial Planner (CFP) in 2005 and advises clients on technical issues pertaining to investments, employee benefits, estate planning, taxes and insurance.
