uExpress.com: Scott Burns by Scott Burns -- (11/18/2012) TARGET MUTUAL FUNDS: OOPS, THEY GLIDE THE WRONG WAY

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TARGET MUTUAL FUNDS: OOPS, THEY GLIDE THE WRONG WAY

11/18/2012

Some ideas give us great comfort and security. They're also easy to market since we all like comfort and security. That's one reason "target-date" mutual funds have been the big idea in 401(k) plans since they were introduced about 20 years ago.

Today, many 401(k) plans have target-date funds as the default selection if a worker fails to pick a particular fund -- and plan sponsors feel safe making that decision. In 2009, according to a report from the Employee Benefit Research Institute, 43.2 percent of all 401(k) participants used a target-date fund if their plan offered one.

Too bad target-date funds don't work.

While questions were raised after the 2008 market crash when target-date funds failed to protect the assets of many near-retirees, the marketing blitz for the funds has continued unabated. They are easy to explain, they're a good story, and workers can make a single decision that will last through their working careers. So what's not to like?

Well, how about lack of efficacy? They don't do what they are supposed to do. Indeed, I believe the idea just received a fatal shot from Rob Arnott, the creator of fundamental indexes. He's also a man who loves to ask awkward financial questions, the kind that often prove the conventional may not be wisdom.

Writing in a recent note from his firm, Research Affiliates, Arnott examined the futures of three workers with different investment paths.

"Prudent Polly" invested in a target-date fund that slowly reduced from 80 percent equities to 20 percent equities over her 41 years of working. "Balanced Burt" had an identical career and savings, but invested in a fixed 50/50 mixture of stocks and bonds. And "Contrary Connie" did just the reverse of Prudent Polly. She started with 20 percent equities and increased her commitment to 80 percent equities over the same 41 years. (Arnott used 141 years of investment data to examine the distribution of results.)

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Now guess. Who did best?

It wasn't Prudent Polly. Not only did Balanced Burt and Contrary Connie do better than Prudent Polly on average, they also did better over the worst time periods all the way up through the best time periods. So the idea of a career glide path, of prudently decreasing exposure to equities as you approach retirement, sounds good and feels good ... but it simply doesn't work.

If Prudent Polly saved $1,000 a year in inflation-adjusted dollars, she would accumulate enough for a life annuity of $4,590 a year if her results were in the bottom 10 percent of all periods and $11,180 if her results were in the top 10 percent of all periods. Bottom results for the two alternatives were virtually the same, while the upside results were the same or better. Balanced Burt ended up with $11,760 in the top 10 percent periods, while Contrary Connie ended with $15,070 in the top 10 percent periods. Quite a difference.

Arnott wasn't satisfied with back-testing the past. He also asked another question: What would the results be like if risks were the same but returns were lower? Since he, PIMCO's Bill Gross and many others are expecting a sustained period of lower returns going forward, that's not an unreasonable question to ask. So Arnott reduced the average annual real return on bonds from 3.9 percent to 2 percent and the average annual real return on stocks from 8.3 percent to 5.4 percent. Then he recalculated.

The result? All three investment methods built smaller accumulations due to lower returns, but the disadvantage of target-date funds remained. While results in the worst performing periods were virtually the same for all three investing methods, the contrary method resulted in a significant advantage in average or better investing periods.

While Prudent Polly accumulated enough for a life annuity of $3,390 a year at the 50th percentile and $5,230 at the 90th percentile, Balanced Burt reached $4,010 and $5,300, respectively, and Contrary Connie reached $3,890 and $6,630.

This leaves us with three questions.

-- How long do you think it will take before the mutual fund industry says anything about this? (Answer: Don't hold your breath.)

-- What were mutual fund industry research departments doing over the last 20 years? (Answer: Nothing that had to do with improving results for you and me.)

-- Where should we be investing our money? (Answer: Probably in a traditional balanced fund with equity exposure of 50 percent to 75 percent. That range has appeared to be "the sweet spot" in many research reports.)

On the Web:

-- Rob Arnott, "The Glidepath Illusion," Research Affiliates, September 2012: researchaffiliates.com/ideas/pdf/fundamentals/Fundamentals_Sep_2012_The_Glidepath_Illusion.pdf

-- Craig Copeland, "Target-Date Fund Use in 401(k) Plans and the Persistence of Their Use, 2007-2009," Employee Benefit Research Institute Issue Brief, August 2011: ebri.org/pdf/briefspdf/EBRI_IB_08-2011_No361_TDFs.pdf

-- Scott Burns, "Index Funds: The Next Generation" (11/28/04): assetbuilder.com/blogs/scott_burns/archive/2004/11/28/Index-Funds_3A00_-The-Next-Generation-_2800_2004_2900_.aspx

(Questions about personal finance and investments may be sent by email to scott@scottburns.com. Please visit www.assetbuilder.com to comment on any of his articles, find referenced web links or to discuss personal finance topics on his forums. Questions of general interest will be answered in future columns and on the website.

(Scott Burns is a principal of the Plano, Texas-based investment firm AssetBuilder Inc., a registered investment adviser. The opinions of this article do not necessarily reflect the views of AssetBuilder Inc. This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, product or service.)