Invesco Ltd. and Pacific Investment Management Co. are adding riskier assets and complicated strategies in target-date funds as they seek to gain ground on Fidelity Investments and Vanguard Group Inc. in this fast-growing segment of the U.S. retirement market.
While sellers promote the funds as a simple choice for people who don’t want to pick their own investments and rebalance them, money managers are using inflation hedges and derivatives to bolster returns. That broadening doesn’t address target-date funds’ main issues: uneven returns, higher expenses and an inability to provide for individual retirement needs, said Bob Pozen, a senior lecturer of business administration at Harvard Business School and former chairman of MFS Investment Management.
Target-date mutual funds hold a mix of assets that become more conservative as employees age, which is why employers favor them when automatically enrolling workers in 401(k) retirement plans. Investments in the funds have swelled more than 380 percent since 2005 to about $343 billion as of September, according to the Investment Company Institute, a Washington-based trade group for the mutual-fund industry.
“Some people are losing sight of the risk-management goal by adding all these additional asset classes,” said Jim Lauder, chief executive officer of Global Index Advisors, whose Atlanta-based firm runs about $14 billion in target-date fund assets for Wells Fargo & Co. and State Street Corp. “If you devastate their portfolios, inflation doesn’t matter.”
The funds’ growth has attracted attention as studies, including those by the Government Accountability Office, have shown that Americans may outlive their savings. Less than 15 percent of Americans are very confident they’ll have enough money to live comfortably in retirement, the Washington-based Employee Benefit Research Institute said in a study yesterday.
Invesco and Pimco are trying to attract assets by using more exotic strategies, which generally have higher fees, said Laura Lutton, an editorial director in the fund research group at Chicago-based Morningstar Inc.
Invesco uses exchange-traded futures and some swaps on futures to invest in commodities such as oil and soy meal, said Scott Wolle, chief investment officer of Invesco Global Asset Allocation. It also uses the derivatives to trade in six global equity markets and sovereign bond markets, including Australia, Japan and Germany. Atlanta-based Invesco started offering target-date funds in 2007 and has about $256 million in assets, Wolle said.
“There’s complexity in the guts of how we manage the portfolio but there’s a simple approach,” he said. “We’re trying to win by not losing.”
Invesco’s target-date fund for those retiring in 2020 returned about 9.8 percent last year with dividends reinvested, according to data compiled by Bloomberg. The average target-date fund lost about 1.6 percent last year, Morningstar data show, while the Standard & Poor’s 500 Index gained about 2.1 percent with dividends reinvested.
Pimco’s offerings saw a 398 percent jump in assets last year to reach $180 million, said John Miller, head of U.S. defined contribution and retirement for the firm. The Newport Beach, California-based company uses derivatives in its target-date funds to hedge against inflation, credit risks and currency dislocations by purchasing options contracts, futures or swaps, Miller said.
Derivatives are financial instruments used to hedge risks or for speculation. They’re derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.
Pimco uses derivatives “to hedge against severe market dislocations and shocks,” Miller, who’s also a managing director at the firm, said. “While the hedges do cost something in terms of putting them into the portfolio, they have the potential to not only pay for themselves but they can and have been a source of out-performance at least historically.”
The firm’s target-date fund for those retiring around 2020 returned about 2 percent with dividends reinvested last year. The firm started selling its target-date funds about four years ago because of their increased use by 401(k) plans, Miller said.
Target-date funds generally are designed to build capital by holding mostly stocks when an employee is younger, and shift to more conservative assets such as bonds as retirement approaches and the need for steady income increases. The federal government endorsed the funds in the Pension Protection Act of 2006, leading employers to favor them when automatically enrolling workers in 401(k) plans, and triggering an influx of money and companies that sell them.
The majority, or 53 percent, of plan sponsors that automatically enroll participants in 401(k)s use target-date funds as the default investment, according to a 2011 report by the Plan Sponsor Council of America, a Chicago-based trade group. There are more than 40 target-date mutual fund families employers may choose from and some sellers also offer them in collective trusts or customized versions, said Jeremy Stempien, director of investments for the retirement solutions group at Morningstar Investment Management.
“We can see tremendous discrepancy, tremendous differences among asset managers,” said Harvard’s Pozen, who’s also a senior fellow at the Brookings Institution. “I don’t think most people understand what they’re getting.”
Fidelity, Vanguard and T. Rowe Price Group Inc. controlled about 75 percent of the target-date assets in 2011, according to Morningstar. The average fee for a target-date mutual fund last year was about 1.1 percent, according to Morningstar, which included all share classes and retirement years such as the 2030 or 2040 funds.
Fees for the funds at Pimco and Invesco averaged about 1.2 percent. Vanguard, which mainly uses three broad-market index funds in its series, had the lowest expenses at about 19 basis points, or 84 percent less than the more expensive funds. A basis point is 0.01 percentage point.
Vanguard reported yesterday that in 2011 about 64 percent of new enrollees in 401(k) plans administered by the company invested solely in a target-date fund. The Valley Forge, Pennsylvania-based firm managed about $100 billion in the funds as of Feb. 29, according to spokeswoman Linda Wolohan.
“Folks are being defaulted into these target-date funds,” said Ron Surz, developer of a target-date series called the Safe Landing Glide Path, which moves investors’ assets entirely to Treasury Inflation Protected Securities, or TIPS, by their projected retirement date. “They think their employers are looking out for them, but they’re just flipping their assets into what’s convenient.”
In 2008, some target-date funds designed for those near retirement lost as much as 41 percent while the S&P 500 Index fell about 38 percent, according to Morningstar. Since then many providers have diversified their holdings and added asset classes to protect against inflation and falling markets.
Providers including JPMorgan Chase & Co., AllianceBernstein Holding LP, Northern Trust Corp. and State Street Global Advisors have increased allocations to inflation-sensitive assets including real estate investment trusts, commodities or TIPS. Last quarter Fidelity also tacked on floating-rate debt and real-estate debt as asset classes, said Joe Cullen, institutional portfolio manager at the Boston-based firm.
The proliferation of investment choices has made it harder for employers to shop for the best plans.
“It’s getting more and more difficult for employers to vet target-date funds,” because there are so many variations with little track record, said Mark Wayne, CEO of Freedom One Financial Group. It’s especially tough for small businesses with fewer resources, said Wayne, whose Clarkston, Michigan-based firm advises companies with 100 to 1,000 employees on 401(k) plans.
Companies must show they’ve made a good-faith examination of their investment offerings in order to avoid liability under Department of Labor rules, said Wayne.
“The problem is, if you take the wrapper off and you look at the underlying funds in the target-date fund, some of those will fail any investment screening,” he said. Businesses should push for target-dates that are comprised of funds from different investment managers to get the best returns for their workers, he said.
“This is going to be their sole retirement vehicle,” said Robin Diamonte, chief investment officer for United Technologies Corp., which uses a customized target-date fund as the default investment when automatically enrolling new hires in its 401(k) plan. “We think it’s extremely important to get it right.”
The maker of Sikorsky helicopters and Otis elevators has about 100,000 participants in its 401(k) plan with about $16 billion in assets, of which about $1 billion was held in target-date funds as of January.
Workers may be better off with a so-called balanced fund that has 50 percent to 60 percent in equities and 40 percent to 50 percent in bonds because target-date funds generally have more moving parts and higher fees, said Pozen of the Harvard Business School.
T. Rowe Price’s Balanced Fund has returned about 5.5 percent in the past 12 months as of March 12 compared with a gain of about 3.8 percent by the firm’s target-date fund for those retiring around 2050. The 2020 target-date fund has returned 4.6 percent in the same time period, data compiled by Bloomberg show.
Target-date funds generally are going to have a higher equity allocation than a balanced fund for a period of decades while a worker is saving, which will tend to produce better returns over longer time periods, said Jerome Clark, portfolio manager of Baltimore-based T. Rowe’s retirement funds. About 90 percent of T. Rowe’s target-date funds are invested in stocks until investors reach age 40 and by the time they are around their expected retirement age that figure has dropped to about 55 percent, he said.
Participants and plan sponsors have adopted target-date funds because they save investors from common mistakes such as lack of appropriate diversification, not rebalancing or buying high and selling low, Clark said.
“I don’t think it has over the period of time a big return advantage,” said Pozen, referring to target-date funds. “But unfortunately you’re getting more investor confusion.”