Pandemic Heightens Concerns About Target Date Fund Risk: Most Are More than 85% in Risky Assets at Their Target Date

  • Target date funds (TDFs)  have grown tenfold since 2008, when they lost 30%, from $200 billion to $2.5 trillion.
  • Recent COVID-induced losses have alerted investors to the risk in TDFs;  baby boomers cannot afford this risk.
  • An accurate appraisal of TDF risk includes all risky assets – equities, long term bonds, etc. Most TDFs are more than 85% in risky assets at their target dates.

Just because nobody complains doesn’t mean all parachutes are perfectBenny Hill

Until now, it seemed that stock and bond markets would always go up in value so any TDF would do. In practice, most of the $2.5 trillion in TDFs has been invested with a handful of providers. Procedural prudence pretty much dictates that you have to hire who everyone else is hiring. But substantive prudence became an issue when the providers set off alarms by losing 20% in just 30 days due to the COVID-19 pandemic. Investment consultant surveys report that losing more than 10% for those near retirement is unacceptably excessive.  The following graph shows losses sustained in 2020 funds intended for people retiring this year.  There are big differences in TDF risk at the target date. In my opinion, most are too risky for baby boomers and are the “Industry” in the next graph. By contrast, a few protect at the target date, like the SMART Funds in the exhibit.

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As shown on the left, the SMART Funds® Target Date Fund Index held strong in this COVID-19 meltdown, just as it did in 2008, 2011, and 2018.

Others are concerned too 

Several recent articles have urged fiduciaries to reassess their TDF risk exposure:

There is a fairly good chance that the days of lucrative investment returns are over,  even though the federal government is doing all it can to keep the party alive. For now, the stock market is recovering because investors are overdosing on “Hopium,” believing the markets will soon return to where they were in 2019.

 

Assessing the risk

Now is a good time to reassess your TDF risk, before Hopium wears off. While risk analyses of TDFs usually define equity exposure as risk, they miss a lot of the true risk exposure. The fact is that long-term bonds are risky,  especially since bonds currently have exceptionally low yields. Even a modest 5% increase in interest rates will generate a 30% loss in bond values because as interest rates have declined, bond duration has increased. Duration is the multiplier to apply to interest rate changes. A duration of six says bond prices will decline by 6% for every 1% increase in interest rates.

Below is a holistic view of TDF risk as equities plus bonds.

The typical TDF is 85% in risky assets at the target date compared to  10% in risky assets in the SMART Funds®. Stated another way, the typical TDF is more than eight times as risky as SMART Funds®. Safe assets are short term bonds like T-bills and stable value.

Conclusion

Risk is more than just equity allocation, the customary metric in TDF  profiles. Risk is the possibility of losing money. Long-term bonds will lose money when interest rates rise. While you can be the judge of this risk, ignoring it is tantamount to ignoring more than one-third of the true risk in the typical TDF.

Fiduciaries should reassess the risk in their TDFs, . The best fiduciary protection is beneficiary protection.