Target date funds and the circular reference problem

The Pension Protection Act of 2006 gave a stamp of approval to auto-enrollment in Defined Contribution (DC) arrangements, and set the stage for the widespread adoption of target date funds (TDFs) and, to a lesser extent, managed accounts. Monitoring the progress of a TDF has a subtle twist, however.

TDFs invest with a specific goal in mind

Target date funds are a good solution to the problem of how to choose an investment strategy that is broadly appropriate for a wide range of individuals whose circumstances are not all the same. Each plan participant is free to opt out and set a customized strategy if they choose, but most don’t do that. So TDFs are built with a specific goal in mind (building up a pot of money that will provide income throughout retirement) and are practical, simple and cost-effective.

But there is one structural challenge for the TDF sector, to which nobody has yet come up with a really satisfying solution. This is the problem of keeping providers’ focus on the true end goal when the most immediate competitive pressure they face is to outperform their peers.

It might seem like it makes sense to judge TDFs using peer comparisons. After all, every 2040 fund (for example) is pursuing the same goal: invest for the retirement of an individual expecting to stop working in the year 2040. But the problem arises with what I call the circular reference problem.

The circular reference problem and where it can lead

To illustrate what happens when peer group considerations are too prominent, let me take you back a few years to early in my investment career and the UK pension market of the early 1990s.

At that time, the most common objective of pension plans in the UK was to outperform the universe of other plans. The justification given for this approach was pretty much exactly the logic mentioned above: plan characteristics did not differ greatly. One side-effect of this objective was that over the course of the 1980s and 1990s, the average equity allocation drifted up. That’s because in a prolonged bull market, it pays to have a slight overweight to equity. So each individual money manager would tend to look at the peer group’s allocation to equity and set their allocation slightly above that. This pushed the average allocation up. Here in the U.S., people still talk of a 60/40 allocation as being the center of gravity for long-term investors, but even by the early 1990s, you were more likely to hear Brits talking about 70/30.

But it didn’t end there.

In the mid- to late-1990s, the UK manager community shared a view that the U.S. market was overvalued. Everyone wanted to be underweight the U.S. market relative to everybody else, and a race to the bottom ensued. It reached the point where UK plans in aggregate held more in a single domestic stock (BP) than they did in the U.S., the largest stock market in the world. There were even some plans who had no U.S. investments at all for a time.

The challenge for the TDF market

This same cycle has started to appear in TDFs. The best short-term performance – and the best chance of winning new assets – is achieved by those with the right tactical biases, not by those with the best long-term strategy. Recently, that’s meant having a big home-market bias during a period of U.S. market and U.S dollar strength.

In the UK, the circular reference problem arose from poorly-defined objectives, and a solution was easy to hand: strategic allocation and customized benchmarks gradually became standard practice. For TDFs here in the US, peer group pressure comes not from the formal objectives of funds, but rather as an indirect side-effect of the way funds are, in practice, evaluated. (I plan to expand in a future post on this point, and why it’s harder for TDFs to define exactly what the right benchmark should be. That’s for another day, though.)

I am not suggesting that TDFs are even close to getting into the extreme situation that the UK market found itself in. But the same underlying pressure is there, and the industry needs to be diligent in keeping allocations focused on what’s suited to the long-term goal, not just on performance league tables and peer-relative positioning.

1Described in Gillies, J. and J. Ilkiw (1999) “A Multinationals Index - Should We Bend the Indices or Just Straighten Our Thinking?” Russell Investments London Monograph.