- We’ve known since 2008 that retirement plan fiduciaries are exposing older beneficiaries to excessive and unnecessary risk in target date funds.
- The Coronavirus has infected a million people, but its financial reach extends to 7 billion people. It would be a shame to not learn from this disaster.
- Investment losses caused by the Coronavirus expose scandalous fiduciary breaches. This time those breaches should not be allowed to continue.
- Retirement investors need to protect themselves, taking control of their wealth in both TDFs and IRAs. Both are 60/40 stocks/bonds for older people.
“You can learn a lot from your mistakes when you aren’t busy denying them.”
― Oscar Auliq-Ice, Author
Very few investors have a grasp on target date fund (TDF) safety and prudence. Even professional investment advisors are ill-informed. The Coronavirus provides a great learning opportunity. It would be a shame to waste it. Until now, the riskiest TDFs were performing best, but they are the most imprudent, and the Coronavirus exposes the cost and pain of this imprudence. Individual Retirement Account (IRA) investors can also learn from the Coronavirus crisis. Incredibly, IRAs are 60/40 stocks bonds on average regardless of age. Imprudence is fine, until it isn’t.
The Coronavirus-induced market crash is an eye opener that should not be ignored. The worst is not yet be over, and there will be other market crashes in this decade, even after this disaster is behind us. The critical investment lesson of the Coronavirus is that prudence can and has defended in this current crash. It will defend again in the next market crash. A related lesson is that imprudence comes with a cost.
The history of TDFs shows that prudence wins by not losing, as we document in this article. Investors should not take the risk that most TDFs have at the target date, namely 60% in equities with the balance in risky long-term bonds – the same risk that lost 30% in 2008. Similarly, Individual Retirement Accounts (IRAs) are taking excessive risk.
Fiduciaries have failed to protect their most vulnerable dependents. This breach of fiduciary duty was obvious in 2008, and now the Coronavirus has reminded us of what wasn’t learned back then. “Those who do not learn history are doomed to repeat it.” Most investors in the Risk Zone spanning the 5-10 years before and after retirement are taking more risk than they can afford because they rely on others to make this risk decision for them, and that decision has been imprudent. I present the details of the scandal in this article and in our recent Scandal Video.
It’s hard to imagine that anything good could come out of a pandemic, but this one has exposed a scandal in retirement savings plans, specifically 401(k) plans and individual retirement accounts (IRAs). It’s a scandal that was previously exposed in 2008 but allowed to continue. It would be a crime to ignore it this time. There are two fiduciary breaches that are scandalous:
1. Fiduciaries, namely investment advisors, are breaching their duty of loyalty by not vetting their TDF selection. Self interests are taking precedence over beneficiary interests, violating the SEC’s Best Interest (BI) standard .
2. Fiduciaries are breaching their duty of care by turning a blind eye to the risk near the retirement date in the TDFs they choose, exposing beneficiaries to excessive risk. Fiduciaries are responsible for harm that should have been avoided.
TDFs are not vetted
Investment consultants have limited their TDF considerations to just 3 firms – Vanguard, Fidelity and T. Rowe Price. These are fine firms, but there are better, more prudent TDFs. Fiduciaries want to protect themselves even if it means exposing beneficiaries to excessive risks. Advisors are operating on the false beliefs that:
This failure to vet has created an oligopoly, which is a market structure in which a small number of firms has the large majority of market share. An oligopoly is similar to a monopoly, except that rather than one firm, two or more firms dominate the market. A monopoly is a market structure dominated by one firm.
As reported in this Sway Research Report, and shown in the following graph, the target date fund market as a whole is an oligopoly, while the passive segment of this market is a monopoly.
The Big 3 trio of Vanguard, Fidelity and T. Rowe Price is an oligopoly, having a large share of the TDF market.
Oligopolies and monopolies are never good. According to Investopedia : the economic and legal concern is that an oligopoly or monopoly can block new entrants, slow innovation, and increase prices, which harms consumers. Firms in an oligopoly set prices, whether collectively – in a cartel – or under the leadership of one firm, rather than taking prices from the market. Profit margins are thus higher than they would be in a more competitive market.
To summarize, the very existence of an oligopoly is evidence that fiduciaries are breaching their duty of loyalty, but that might be alright if this breach did not expose beneficiaries to excessive risks. What constitutes “excessive” is a matter of opinion, as we discuss in the next section.
The 2008 crash was shocking to all investors, but exceptionally painful to those in 2010 TDFs, who lost 30%. These investors were supposed to be protected. That’s the objective of TDFs, to protect those near retirement. The Hippocratic Oath of prudent TDFs is ”Do no harm.” The lesson of 2008 was that TDFs take too much risk near retirement. This definition of “Excessive risk” is “Hurts really bad.”
Another definition of “excessive” is found in surveys. What do beneficiaries and their advisors want for those near retirement? Surveys of retirement beneficiaries and their advisors report that both consider a loss of 10% or more for those near retirement to be excessive. In other words, risk should be limited to guard against losses of 10% or more. The respondents to these surveys might not know about the “Risk Zone” and “Sequence of Return Risk”, but they got the answer right. Simply stated, those nearing retirement cannot afford to take risk – their risk capacity is very low. But most retirement investors have someone else making this decision for them, and that’s where the scandal arises. Fiduciaries are violating their duty of care by exposing those near retirement to excessive risk. Losses suffered by those near retirement this year and in 2008 should have been avoided.
Excessive risk doesn’t end with TDFs. The average Individual Retirement Account (IRA) is 60% equities and 40% long term bonds regardless of age. This is a result of the popular “60/40 Solution” advocated by most consultants. See An Up-close Look at Investment Consulting. Both IRAs and TDFs are taking excessive risk for those near retirement as discussed in “Coronavirus exposes scandal” below. There’s $2.5 trillion in TDFs and $10 trillion in IRAs, amounts deserving safety awareness.
The justifications for excessive risk are that people don’t save enough and they are living longer, but these are excuses rather than justifications. Prudent TDFs perform about the same as risky TDFs over the long run, as described in “Win by not losing” below. The following graph shows current glidepaths relative to survey preferences.
Here are the main points in this exhibit:
- The Big 3 are 55% in equity in the Risk Zone. Most of the balance is in risky long-term bonds (not shown)
- IRAs are even riskier than TDFs in the Risk Zone
- Surveys (orange line) reveal that respondents (consultants and beneficiaries) want low risk in the Risk Zone.
- Consultants say one thing in surveys – be safe in the Risk Zone — but do not follow their own advice when they select unsafe Big 3 TDFs.
- There is a safe TDF, shown as “SMART” in the exhibit. It’s the SMART Target Date Fund Index, discussed in the next section.
- The SMART Funds re-risk in retirement, following the recommendations of Dr. Wade Pfau and Michael Kitces. The Big 3 cannot re-risk because they begin retirement at the height of post-retirement investment risk.
Coronavirus exposes scandal
There is no accepted standard for target date funds, but Target Date Fund Benchmarks discusses a few possibilities. The SMART Target Date Fund Index tracks the patented Safe Landing Glide Path. Its objective is to not lose beneficiary savings. SMART is a Substantive Prudence benchmark, doing what’s best for beneficiaries. The S&P Target Date Fund Index is another possible standard that is a Procedural Prudence benchmark, following the herd as a composite of all TDFs
As shown in the following exhibit, the average (S&P) near dated 2020 TDF has lost 11%, which meets the survey definition of excessive risk, and this crisis is not yet over. By contrast, SMART’s Today (for current retirees) and 2020 funds have defended well, losing very little.
At 60/40 stocks/bonds, IRAs are most like 2030 funds in the exhibit, losing between 12% and 15% regardless of age, below the excessive risk 10% loss definition for baby boomers.
Focusing on 2020 funds, the following exhibit compares the Big 3 2020 funds to each other, and to SMART. All of the Big 3 funds have lost more than 10% so far, while the SMART 2020 Fund lost only 1.5%, well above the threshold for “Excessive.”
These performance results can be better understood by reviewing asset class performance in the quarter, as shown in the following graph.
As you can see, there were only a couple places to hide in the quarter, namely gold and US bonds.
Win by not losing
The SMART Funds have a history of defending. They were the best performing funds in 2008, 2011, 2018 and now 2020. But they lagged the industry in general during the unprecedented 12-year stock market rebound that started in 2009. Imprudence was rewarded during this longest stock market rebound in history. But, as shown in the next exhibit, SMART has performed in line with the industry over the history of TDFs, but with far less volatility.
Because near dated Today and 2020 SMART Funds defended well in 2008, their performance exceeded the Industry for about 7 years, but nobody knew. Then the Industry’s concentration in US stocks overtook SMART. But the Coronavirus put SMART long-term performance back in line with the Industry, literally overnight. The trend indicates the Industry crossing below the SMART asset level in the near future.
The long-dated SMART 2050 Fund has a similar story, but it’s been its broad diversification that has made a difference, integrating alternatives like commodities and precious metals.
There are only three other TDFs with performance histories that are similar to SMART. All the other TDFs are copies of the Big 3.
Drastic government interventions could have drastic consequences. The world experienced stagflation in the 1970s when inflation spiked during a recession; throwing money at the problem backfired. Central banks have responded to the Coronavirus by injecting $ trillions into their economies, which will generate Demand-Pull Inflation because “too many dollars will be chasing too few goods.” Until now, such “Quantitative Easing” did not generate inflation because most of the money went into stock and bond markets rather than consumer goods, so “velocity” was low. But this new money will be spent on food and other necessities. Inflation could trigger The Debt Spiral that economists have worried about for decades. It could get very ugly.
No one knows how much deeper market losses from this virus will extend, but one thing is certain: there is excessive risk in TDFs in the Risk Zone as well as in IRAs, as evidenced by current losses in excess of 10%.
In Coronavirus Shock Is Destroying Americans’ Retirement Dreams , Bloomberg Business Week reports that “ For older people, the coronavirus crisis has been an appalling shock. Their life savings are melting as the global economy shuts down and financial markets plummet. The pain may be particularly acute in the U.S., where Americans rely on a retirement system that was broken well before a pandemic dashed it to pieces.” The article tells the sad real life story of a person who has been hurt badly by recent investment losses in her 401(k). Older people suffer the most.
Improving TDFs and IRAs
In addition to the excessive risk scandal discussed in the preceding, TDFs suffer from the one-size-fits-all problem. All participants in a TDF are following a glidepath to who knows where along with hundreds or thousands of people who are not like them. Both of these problems can and should be solved with personalized target date “portfolios.” Portfolios are individually managed to achieve your needs and goals. By contrast, Funds are commingled vehicles, usually mutual funds.
IRAs have an even worse problem. They’re the same 60/40 stock/bond mix regardless of age.
Individual investors can benefit from the discipline of risk control in TDF glidepaths by designing their own lifetime investment path, outlined in the following graph.
The exhibit highlights three main risk decision points: (A) risk when you’re young, (B or B’) risk as you transition from working life to retirement, and (C) risk in retirement. All 3 are important, but we believe B to be the most important, and strongly urge you to seek the help of an investment advisor who understands glidepaths and your needs. The U-shape in the exhibit’s Recommended Path is important to understand and use.
Like all previous pandemics, this one will end, and financial markets will recover somewhat, but there will be other market crashes in the future, as we warn in our 2/18/20 Ten Threats to US Stock and Bond Markets. Coronavirus is one of the 10 threats we warned about; there are 9 more, each capable of causing another market crash. Stock and bond markets have teetered on the brink of collapse for some time. The Coronavirus precipitated the inevitable. Now is the time to protect your retirement savings, and to stop the scandal. The scandal is excessive risk near retirement.
Many advisors are recommending that you “buy the dip” and “stay the course” because stocks will rebound when the crisis ends. We see things a lot differently for people in the Risk Zone who are taking excessive risk, which is most of them. They should consider using this opportunity to reduce their risk. It’s like starting a weight loss program after you lose weight from being sick. Instead of buying now, you’d sell stocks and long-term bonds on the rebound and invest in safe T-bills and TIPS. Rather than “buy into weakness” you’d “sell into strength.”
For more detail on what to do now, see our Smart Investing video, the Four Pillars of Smart Investing article, and the Smart Investing Infographic . This is not about market timing. It’s all about risk management. People near retirement cannot afford much risk because losses result in lifestyle sacrifices and a reduction in the length of time that savings last.
Reliance on others to make a prudent risk decision has been a mistake. Fool me once, shame on you. Fool me twice, shame on me. Despite a recent stock market recovery at the time of this writing, the Coronavirus is just beginning in the US and Europe. It would appear that investors believe/hope a cure is near but scientists tell us that will take at least 6 months, although there are medications that might alleviate some of the symptoms, without stopping the spread. Coronavirus is not over yet. And when it’s gone, we should not forget the investment lesson it has taught us.
Stop the excessive risk taking now.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.