Reinventing the Target-Date Retirement Fund

Target-date funds were supposed to offer financial security to workers approaching retirement. The funds, marketed largely through 401(k) plans, shift to an ever more conservative asset mix as an investor's retirement date approaches. But rather than provide comfort, many of these funds delivered nasty surprises to investors during the market downturn. The worst performer among target-date funds geared toward near-retirees was Oppenheimer Transition 2010, which fell 41% last year, largely because it was nearly two-thirds in equities.

The huge performance gap between the best and worst of these funds, which New York-based research and consulting firm Strategic Insight says have $187 billion in assets, has stirred debate among investors and policymakers. At issue is whether the funds should have tighter regulation, particularly as they're often the default option for employees who don't make investment choices in 401(k) plans. In the wake of Washington hearings, new disclosure requirements seem likely, and restrictions such as capping how much stock a fund nearing its target date can hold are being discussed. Imposing limits would be tricky, though, and the industry vows to fight such strictures.


The basic concept of target-date funds remains a good one. Studies show that investors consistently make the wrong investments at the wrong times, and that holding a diversified portfolio is smarter than making concentrated bets. But many investors share the misconception that funds with the same target dates, which generally range from 2010 to 2050, are largely interchangeable in their strategy and investment mix. Equity allocations vary wildly, and funds differ in how the asset mix changes as investors near targeted retirement dates.

Amid the controversy, the fund industry is busy developing the next generation of target-date funds. One approach would break apart the notion of a prepackaged target-date fund in which all the asset classes are managed by the same firm. Companies such as AllianceBernstein (AB)—whose target-date funds have some of the highest equity weightings—are pushing the idea of "open architecture," in which different managers are used for different parts of the fund. And some large corporations are creating custom target-date portfolios from their investment lineups, designing the asset mix with an eye on workforce demographics and whether there's a pension plan.

Some observers believe the industry is already correcting itself. Management fees are falling, and underperforming funds are being weeded out, says McKinsey consultant Onur Erzan. "It usually takes two or three tries to get the products right," he says. "The next generation of products will correct deficiencies that the current crisis revealed."

Consider Intel (INTC)'s approach to customized target-date funds. The chip giant began offering target-date funds that it created in-house in 2004. Intel's director of retirement investments, Stuart Odell, says creating its own funds rather than using prepackaged ones gave it flexibility in the asset mix, lower fees, and a stable of best-in-class asset managers. "I might want to hire BGI [Barclays Global Investors] for indexing, but would I want them for active management?" he asks. "Do I want Fidelity for fixed-income as well as equity? We wanted best-in-breed for all asset classes."


By creating target-date portfolios in-house, Intel can mix in asset classes not typically seen in the funds, such as hedge funds and commodities (which it will add later this year) and private equity and real estate (to come in the next few years). Intel's target-date funds account for some $200 million of its $3 billion 401(k) plan, and its fees are low, from 0.10% to 0.12%.

In a yearend 2008 survey of large plan sponsors by Callan Associates, San Francisco-based consultants, 25% had a custom fund targeted by age or risk profile, or would add one this year, vs. 18% who said that two years ago. "A few years ago the funds were viewed as a commodity, and you almost defaulted to ones offered by your record-keeper," says Lori Lucas, head of Callan's defined-contribution practice. "Last year demonstrated the tremendous difference in what's out there. It was a wake-up call to plan sponsors that they need control of what's in their plans."

The other big question is whether a guaranteed-income product will become part of the target-date mix. BGI has developed a product that would add annuities to a fund structure (BW--Feb. 16). And AllianceBernstein is working to design a multi-insurer guarantee into its product. The idea behind using multiple insurers is to lower the risk should any one insurer have financial trouble, says Thomas J. Fontaine, head of defined contribution. For now, adoption of guaranteed products remains relatively low, as plan sponsors wait to see how the markets—and employees' existing retirement portfolios—shake out.

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