Why I use target date funds for some 401(k) clients in my RIA but with exaggerated scrutiny and care

Good article, but it is important to note that like 401k plans, target date funds are the most successful retirement savings/investment vehicles ever launched. Critics cannot alter those facts. Like other investments, they can never be perfect. The need for determining objectives and performing due diligence is obvious, but TDF objectives must be determined by plan sponsors and investors, not advisors, vendors, critics, the media and/or other observers. The market for custom asset allocation solutions is growing rapidly in all market segments. Liquid Alts are also starting to show up as diversifying fixed income sleeves. However, it should be noted that actively managed and totally proprietary TDFs from T. Rowe Price, the American Funds and TIAA-CREF have been shooting the lights out. Finally, it should be noted that in aggregate, TDFs are not and have not been benchmarked properly, a shortcoming waiting to be exploited by the Tort bar. Given the changing fixed income dynamics, it is also time to recognize that equity based glide paths are no longer an accurate measurement of risk.

Excellent article. I’d like to add some points to from quotes from the article:

• “Investors cannot afford the unnecessary risk of most target date funds. Capital preservation can no longer be an afterthought, for both individual investors and fund companies alike.”

The maximum drawdown from peak of the three largest TDF families exceeded 32% in March 2009, less than one year from the target date. After the fact, pension consultants agreed the amount of risk being taken by TDFs was much greater than they had assumed and much larger than appropriate so close to retirement dates.

My historical analysis from 1928-2013 of a static 60% stock/40% bond portfolio—which is similar to the allocations of the major TDFs at the target date—shows a maximum drawdown of 60% from peak, far too much risk for someone about to retire.

Research shows that investors react poorly to even moderate-sized losses, abandoning the investment, locking in losses.

• “Without a crystal ball for the capital markets, glidepaths are inherently mistaken. They create a predetermined allocation without consideration of market conditions….The key is to be able to tactically shift the asset allocations depending upon market conditions — not blindly following a path that was set under a different economic environment…. These qualified default options must shift from overly aggressive target date funds toward professionally risk-managed portfolios.

I agree that “market blindness” is one of the major drawbacks of TDFs, which rely on glidepath investing. However, if one is going to build-in market conditions to the TDF, there has to be some justification that the methodology is going to provide value-added.

Yale Professor Robert Shiller, 2013 Nobel prize laureate in economic sciences, has said that there’s a pretty good fit between his CAPE ratio and subsequent 10-year stock returns. I devised an algorithm for tactically shifting asset allocations using the CAPE ratio from 1928-2013 and it outperformed static and glidepath allocations by a large degree. However, due to the excess volatility of prices, Shiller’s observation in the early 1980s, the maximum drawdown of the strategy was still quite high.

When I added a hedging algorithm, maximum drawdown could be contained to 20% for a “medium risk” strategy. That compares very favorably to the 60% max drawdown for a 60/40 static allocation.

Risk management is the key to keeping investors’ losses within tolerances so retirees will not abandon their investments after incurring large losses.