Target date funds: What about risk?

In my most recent Fiduciary Corner column, I looked at how fiduciaries can make the difference in reforming target date funds. A question arose however as to where risk is accounted for. An email I received made the case that the products were being made on the cheap, saying "What is missing is the most important factor of all: RISK. These life-cycle funds are fatally flawed as they assume the same risk tolerance for all investors retiring in a certain year. Risk drives behavior. Individuals usually fail because of behavior." The emailer suggested that by not providing subsets based on risk tolerance for each target date year, managers are feeding the same bad investor behavior that causes investor performance to consistently lag behind fund performance.

Risk is obviously an important factor in the construction of a portfolio--second only to time horizon. If an investor has a very short time horizon, i.e. they have an immediate liquidity need, their opportunity to diversify is limited. That is why the question of whether the target date fund is targeting "to" or "through" retirement is so critical.  If the intent of the investor is to invest "to" retirement, a target date fund may be entirely appropriate (ignoring for the moment other correctable flaws in many of the funds I mentioned in my article).

By definition, diversification is intended to manage risk, which is why I assumed it.  Pre-diversified portfolios have risk management as their reason for being. If investors were capable of building and maintaining a customized portfolio themselves or had access to professional advice to help them, target date funds might not be necessary. But keep in mind that these funds are primarily designed for investors who are either unable or unwilling to structure an appropriately designed portfolio for themselves.

To say that a pre-diversified option is "fatally flawed" seems to me to be an overstatement in the same sense that it would be an overstatement to say that no one can ever benefit from buying preassembled furniture. Custom built furniture will generally be superior, but pre-built isn't inherently worthless. Of course, if someone needs a desk and goes shopping for something pre-built but comes home with a dresser, their needs aren't going to be met. There is a certain level of understanding that the buyer needs to have of what they need and what they are buying.

As I indicated in my article, there are currently some inherent problems with target date funds. For example, the "to" versus "through" issue is the equivalent of getting a pre-built piece of furniture without knowing what’s in the box. In addition, the exemption that treats underlying funds in the target date product as not being plan assets allows the provider to have conflicts of interest. But these and other flaws are correctable, not fatal.

To be clear, I am not a big fan of target date funds. However, in the limited circumstance of trying to address the needs of people who are otherwise likely to chase the returns of whatever happens to be the hottest performing fund of the moment, or those who will only park their money in a money market or stable value fund that won't get them to their retirement income goals, new and improved target date funds can play a role (e.g. as a QDIA).