It’s Time to Reconsider Whether Target-Date Funds are Viable

We know the industry’s design of target-date funds never considered major losses aka tail risk. However, tail risks at or around retirement can be detrimental to the participant’s retirement security.

The following paragraphs detail why it’s time for the industry to take a hard look at their role as a steward for plan fiduciaries and then look at these products and whether they meet the definition of diversification.

Diversification means is the plan participant’s portfolio constructed under the principles of Modern Portfolio Theory: The tenet of the plan sponsor’s freedom from investment loss liability.

The Uniform Prudent Investor Act (UPIA)

To understand the central theme of diversification you have to start with The Uniform Prudent Investor Act (UPIA) which is a piece of the Restatement (Third) of Trusts. UPIA sets up principles for the reasonable investment of trust assets. While UPIA isn’t law, a majority of states have embraced it and even though UPIA applies to a trustee’s guardian obligations, it has been used in defining standards for investment advisor fiduciaries.

At the heart of it is the wording: “exercise prudence in diversifying the investments to minimize the risk of large losses.” The effective solution for trustees and fiduciaries is to utilize diversified investment vehicles which meets the standards of Modern Portfolio Theory.

However, any target-date fund should come with a disclaimer: Use with caution. It’s only as good as your presumptions. 

Here are the major losses of the 5 Vanguard Target Date Funds during the Great Recession:

Target

What happened to their diversification?

Research has shown that correlations increase and the diversification benefits of a multi-asset class portfolio even with alternative asset classes fail during periods of market declines. This failure is explored in the paper, When Diversification Fails. In their paper, authors and T. Rowe Price portfolio managers, Sébastien Page, CFA, and Robert A. Panariello, CFA state “One of the most vexing problems in investment management is that diversification seems to disappear when investors need it the most. We surmise that many investors still do not fully appreciate the impact of extreme correlations on portfolio efficiency—in particular, on exposure to loss.” They recommend: “Prudent investors should not use them (correlations) in risk models, at least not without adding other tools, such as downside risk measures and scenario analyses. To enhance risk management beyond naive diversification, investors should re-optimize portfolios with a focus on downside risk, consider dynamic strategies, and depending on an aversion to losses, evaluate the value of downside protection as an alternative to asset class diversification.”

The general shakiness of the relationship of asset classes suggests that asset allocation recommendations and products ought to respond to changes in the economy and the market.

Static asset allocation likewise negates the prudent investing approach, which expresses that “The role of proper asset allocation when diversifying the investment portfolio of a trust: Asset allocation decisions are a fundamental aspect of an investment strategy, and are a starting point in formulating a plan of diversification (as well as an expression of judgments concerning suitable risk‑return objectives). These decisions deal with the categories of investments to be included in a trust portfolio and the portions of the trust estate to be allocated to each. These decisions are subject to adjustment from time to time as changes occur in the portfolio, in economic conditions or expectations, or the needs or investment objectives of the trust.”

Source

Conclusion

A prudent investment approach must consider market conditions. You can’t use backward-looking assumptions to drive the investment process forward. Forecasts should be used to provide advice and develop products that protect against major losses.

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