Target-Date Funds
The rapidly growing popularity of asset-allocation products such as “target-date funds” has been possibly the most significant trend among institutional investment during the last 10 years.
These no-fuss professionally managed funds enable investors to pick out a plan that is designed to meet their asset allocation needs over a long time horizon, and defined contribution retirement plan sponsors have been flocking to target-date funds in droves. A target-date fund’s administrator manages its holdings, reallocating from higher-return to lower-return volatility asset classes according to a predetermined “glide path” to reflect investors’ changing risk tolerance. For example, let’s say you’re 23 years old in 2008 and hope to begin receiving benefit payments at the age of 70. When you invest in a 2055 target-date fund, you entrust the fund manager to tailor your retirement plan portfolio for you throughout your entire 47-year career.
The advantage for investors is that target-date funds remove a number of the headaches that have plagued busy working professionals when it comes to managing their retirement plans. Namely, they no longer have to worry about when and how to adjust their portfolios to account for changes in their risk profile.
A target-date fund’s glide path establishes the evolution of the fund’s allocation among different asset classes as time goes on. The glide path sets a riskier, higher-return allocation early in the life of the fund and progressively dampens its risk exposure and expected returns as the fund matures and investors age.
Trends
Recent research studies illustrate the implications of target-date funds’ rise in popularity for retirement plan administrators.
According to a survey conducted in 2006 by PIMCO, one of the biggest fixed income investment management companies in the world, two-thirds of retirement plan consultants think that target-date funds will soon be the option of choice for defined contribution plans, forcing sponsors to gear up. A 2007 study by human resources consulting firm
Hewitt Associates, for instance, found that 57 percent of retirement plan sponsors already offer life cycle funds, while an additional 39 percent planned to add them to their lineup. Compare that to 1996, when only 12 percent of plans had investment options similar to target date funds, according to
the Profit Sharing Council of America, a national association of 401(k) plan sponsors and participants.
Research also suggests that target-date funds have become especially popular among young consumers. Data from the Employee Benefits Research Institute show that younger consumers just entering the defined contribution plan market have gravitated toward target-date funds
REITs and Target-Date Funds
As target-date funds have gained favor in the investing public, they’ve come under scrutiny as well. In the first issue of a well-read series of target date fund analyses beginning in 2006, retirement benefits consultant Turnstone Advisory Group LLC criticized the “unimaginative asset allocations” of target-date funds. This included underutilizing real estate securities.
A year later, however, Turnstone performed a broader follow-up evaluation of target-date funds. This time, the consultants concluded that the funds had done more to diversify their holdings, which included boosting their exposure to real estate. Likewise, a 2007 survey conducted by Plan Sponsor found that nearly 60 percent of all target-date funds had incorporated a real estate allocation.
Retirement plan experts promote the value of REITs in target-date funds for the same reasons that many investors have embraced REITs as a staple of their own portfolios.
- Performance and diversification:
“The advantage of adding REITs or real estate to one of these funds is pretty obvious—they’re a big diversifier,” says Ruth Falck, a senior investment consultant for Watson Wyatt Worldwide who advises retirement plan sponsors, including major corporations. Falck says she encourages her clients to maintain a real estate allocation of no less than 5 percent in their target date funds.
“The increased popularity may be due to real estate’s favorable returns compared to domestic stocks and bonds, as well as the asset class’s low correlation to both, historically. This provides an excellent diversification tool for a total portfolio,” says Jospech C. Nagengast, president and founder of Turnstone. “We think real estate offers good diversification benefits and should be considered as part of a well diversified, global portfolio.”
“You put a strong portfolio together by including things that behave differently, and REITs behave differently than either stocks or bonds. A portfolio isn’t diversified efficiently if you just buy different types of stocks or bonds, many of which tend to move together,” says noted investment analyst and researcher Roger Ibbotson. “Our conclusion is if you generally have REIT holdings along with stocks and bonds—as opposed to a portfolio of just stocks and bonds—you’ll do better.”
- Hedging against inflation:
“REITs offer important return and diversification potential and are important in stand-alone target date funds. Additionally, given that most participants’ other taxable wealth is in the form of stocks and bonds—assets that don’t typically do well when inflation rises—having more inflation-sensitive assets within their target date funds is a very important diversifier,” PIMCO Executive Vice President Seth Ruthen says.
- Liability-relative investing:
“This is accomplished by structuring the defined benefit assets to minimize the risk that assets will be insufficient to meet the future liabilities or pension payouts of the plan. At PIMCO, we believe this same concept can be applied within defined contribution plans. Plan sponsors should consider the liability as an individual’s need to fund a lifetime retirement income. Given the objective of these assets as providing retirement income, we believe managing as tightly to that need and minimizing the risk of not meeting the objective is critical,” says PIMCO Senior Vice President Stacy Schaus, who laments the lack of REITs and similar asset classes among target date funds’ holdings.”