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Posted June 14, 2007 The full Governing Management Letter | Subscribe to The Governing Management Letter GIRARD MILLER’S BENEFITS BEAT Bonus columns: ‘Target-Date’ Funds Miss the Bull’s-Eye Public employees have different needs. Questions, success stories or anecdotes about benefit issues in government? The mutual fund industry has invented a better mousetrap with a product line known as retirement Target Date funds, or TD funds. These innovative, diversified asset allocation funds now appear in most retirement savings plans offered by state and local governments. Their magic ingredient is that they allow employees to pick a target date for retirement and have investment professionals figure out what percentages of the investors' money should be held in stocks vs bonds vs other investments. For average investors, that's a great package. Most employees haven't even heard of asset allocation--let alone figured it out for themselves. 
TD funds provide a great service to defined contribution plans. Historically, many employees tend to be over-conservative and put their money under the mattress in a money market fund or insurance contract, while others are over-aggressive and bet the ranch on last year's winning stock fund just in time to see the market go the other way. TD funds avoid that problem by offering an age-appropriate blend of investment risks that are presumably suitable for the employee based on how many years they have until retirement. A younger employee hoping to retire in 30 years might invest in a TD 2035 fund that might invest 80 to 90 percent of its assets in stocks. A 55-year old might select a TD 2015 fund with a portfolio now balanced at 50 percent in stocks, the rest in bonds and a plan to reduce stock exposure each year hereafter. Each mutual fund company has a different blend, so the ratios are similar yet distinctive for each fund complex.
Last year, the U.S. Congress passed legislation that relieves employers of fiduciary risk if they offer a TD fund family as the default investment vehicle, which is a great way to assure that defined contribution plans keep pace with the investment results of defined benefit pension systems, which nowadays are widely diversified across asset classes for the long run. Representatives of the financial firms who market retirement savings plans to public employees love the TD funds. They enable the enrollment staff to sidestep the thorny problem of offering personal investment advice, which the Securities and Exchange Commission frowns upon. The asset allocation investment advice is essentially built into the product, which is SEC-registered. So far, so good, but there is a fly in the ointment. None of these Target Date funds take into account the fact that public employees are unlike today's average private-sector 401(k) plan participant who has no other retirement plan. Unlike workers in the private sector, 90 percent of state and local government employees are members of a pension plan. From a financial planner's standpoint, that pension benefit needs to be taken into account in each employee's asset allocation. Unfortunately, the TD funds fail to do that. By design, they consider only the investor's defined contribution assets, not the pension assets. For example, a 50 year old employee with 20 years of service who plans to retire in 10 years with a pension paying roughly 60 percent of her salary already has a huge vested investment in the pension plan. The ultimate future value of that pension is approximately nine times her final salary, and it typically dwarfs the personal retirement accounts held in 457 and 401 plans. Although the pension fund may invest collectively in stocks, real estate and even hedge funds, the employee's personal financial interest in the fund is actually a fixed-income security. Think of the pension as a government bond worth nine times the pension she will receive annually. In this context, a Target Date fund is almost always too conservative, because the employee's actual exposure to the stock market is a far smaller percentage of her total portfolio than the share held in the TD fund. In fact, unless our hypothetical 50 year old employee has a retirement savings account exceeding five times her present salary, a good case can be made that her optimal asset allocation in the defined contribution or deferred compensation plan should be 100 percent in equities for another five years! Certainly for employees under age 45 who have already vested in a pension benefit after 10 years of service, a supplemental savings portfolio with 100 percent in stocks could easily be justified from a risk-return standpoint. Public employees are notoriously risk averse, so I don't want to suggest that market-fearing retirement savers should move money today from balanced portfolios into the fully-priced stock market--especially now when we're already in the 8th inning of this business cycle. But at the bottom of the next recession, I will revisit this strategy and make the case for a more aggressive approach to investments for those who have the security of a defined benefit plan. Meanwhile, public employers should remind employee-investors who use TD funds that one size does not fit all. Last month: Girard Miller, an analyst of benefits and investments with 30 years of experience in the public, private and nonprofit sectors, can be reached at Girardinmalibu@charter.net. © 2007, Congressional Quarterly, Inc. Reproduction in any form without the written permission of the publisher is prohibited. Governing, City & State and Governing.com are registered trademarks of Congressional Quarterly, Inc. |
