Target date funds are taking a closer look at where retirees will end up

By Allen Kenney

Imagine planning a weeklong vacation to a warm island in the Caribbean. You book your flights. You reserve a room at a luxurious resort. Maybe you schedule a round of golf.

You arrive in paradise, check in at the hotel and head for the beach. That's when it starts: $20 for sunscreen; $10 for bottled water; a turkey sandwich from the poolside grill is $18. You realize that you have just enough money set aside for five days of fun in the sun, not seven. Enjoy your vacation.

Now, imagine your retirement playing out that way. Doesn't sound too pretty, does it?

Retirement plan providers have started taking steps to make sure that target-date fund investors don't suffer the retirement version of such a vacation debacle. They're reassessing the design of the all-in-one funds in an attempt to match them to investors' needs. Likewise, they're studying investors' behaviors to look for holes in prevailing theories about how people use their retirement accounts.

"You have to make sure that, first and foremost, you think about the solution you're trying to generate for a retirement plan's participants," says Anne Lester, a senior portfolio manager with JP Morgan Asset Management who has done extensive research on target-date funds. "The goal should be to maximize the number of participants who reach their finish line."

Although the latest research has produced a variety of opinions on how to tailor target-date funds, it seems clear changes are coming that could pay dividends for REITs.

A Closer Look

For those unfamiliar with target-date funds, the term refers to a class of asset allocation funds set up to automatically adjust to clients' retirement goals as they grow older. As investors approach retirement, the fund automatically begins to adjust its holdings to reflect their diminishing tolerance for risk and need for securities that fight inflation and yield income.

In the past five years, target-date funds have become the darlings of defined contribution retirement planning. A 2007 study by human resources consulting firm Hewitt Associates determined that 57 percent of retirement plan sponsors already provide target-date fund options, and almost all of the remainder intended to start offering them to their customers. A separate 2007 survey conducted by Plan Sponsor magazine found that the proportion of plans offering target-date funds climbed from 46.5 percent in 2006 to almost 90 percent in 2007.

Yet, the boom in popularity has been accompanied by greater scrutiny from investment analysts, financial planners and fund providers themselves, all looking for ways to improve the all-in-one funds. Much of the focus has been on target-date funds' so called "glide paths," which guide the portfolios' asset allocations as participants age. For example, in a 2040 fund, the glide path dictates how to periodically adjust the portfolio's asset mix assuming investors in the fund retire around 2040.

Trends in the Industry
Target Date and Target Risk Funds
ORGANIZATION*	REAL ESTATE ALLOCATION
Alliance Bernstein	Up to 10.0%
Barclay Global Investors	Up to 6.0%
Charles Schwab	Up to 5.0%
Dow Jones Indexes	Up to 15.0%
ING	Up to 6.0%
J&W Seligman	Up to 10.0%
John Hancock	Up to 7.0%
JPMorgan	Up to 18.0%
PIMCO	Up to 15.0%
Principal	Up to 5.7%
Russell Investment Group	Up to 7.0%
State Farm	Up to 6.2%
UBS	Up to 10.0%
*Selected Organizations; Source: NAREIT data

In mid-2007, Seth Ruthen, a PIMCO executive vice president who specializes in asset allocation, published an analysis of the early versions of target-date funds, "Creating the Next-Generation Glide Paths for Defined Contribution Plans." Not surprisingly, he found that these forerunners took "simplistic" approaches that induced high risk exposure. He noted that the early target-date funds recommended particularly heavy equity allocations—sometimes as high as 100 percent. As a result, these retirement investments' glide paths "unfortunately tend to generate a wide range of outcomes, producing a few big winners and many losers," according to Ruthen.

In one JP Morgan study published in early 2008 entitled "Sharpening Your Aim," the financial services firm's researchers determined that behavior in areas such as early withdrawals and frequency and size of contributions can have a pronounced effect on the amount of savings available to participants at the time of their retirement.

Another JP Morgan study released in September 2007, "Ready, Fire, Aim?," concluded that target-date fund sponsors tended to base their models on unrealistic assumptions. Also, the researchers found that participants' own "volatility" tended to exacerbate that of the broader market. In other words, behavioral trends like haphazardly upping and decreasing contribution rates add to the variance of each individual participant's returns.

Gliding Down the "De-cumulation" Path

As an example of the misconceptions about target-date funds, Lester says she and her colleagues observed that retirement plan participants often deviate significantly from the assumption that they will draw down their assets in equal increments upon reaching retirement. In fact, JP Morgan's evidence shows that half of the average participant's 401(k) assets had been drained in lump sum withdrawals by the age of 65.

Chris Goolgasian, an institutional portfolio manager for Pyramis Global Advisors, a subsidiary of Fidelity Investments, says his company's research has borne out its own results regarding withdrawal. For instance, while standard target-date forecasting models rely on average annual withdrawal rates of 4 percent, he says Pyramis' research shows that number being closer to 8 percent.

Fund Bios Below are profiles of target date funds that include REITs in their portfolios. JP Morgan SmartRetirement 2050 Fund (JTSAX) STRATEGY: “Uses an asset allocation strategy designed for investors expecting to retire around the year 2050, with the allocation changing on an annual basis, becoming more conservative as the fund nears the target retirement date.” PORTFOLIO ALLOCATION: (as of July 31, 2008) Equities – 85% Fixed Income – 12% Money Market – 2% Short-Term Investment – 1% REAL ESTATE HOLDINGS: (percentage of total portfolio as of July 31, 2008) U.S. Real Estate Fund – 4% • .Primarily invests in U.S. REITs and other real estate companies. International Realty Fund – 3% • .Primarily invests in securities of foreign REITs and real estate companies. Realty Income Fund – 2% • Invests in U.S. equity and mortgage REITs. Barclays Global Investors LifePath 2040 Fund (LPREX) STRATEGY: “Each LifePath portfolio is diversified among broad types of asset classes and is adjusted over time to gradually become more conservative as the year approaches when investors expect to need their money.” PORTFOLIO ALLOCATION: (as of June 30, 2008) Large Cap Stocks – 45.65% Small and Mid cap Stocks – 12.21% International Stocks – 25.97% Real Estate – 5.92% Nominal Bonds – 10.25% REAL ESTATE HOLDINGS: (percentage of total portfolio as of June 30, 2008) BGI US Real Estate Index Fund – 5.92% Schwab Target 2040 Fund (SWERX) PORTFOLIO ALLOCATION: (as of July 31, 2008) Cash – 6.23% Domestic Stocks – 52.23% Foreign Stocks – 25.61% Domestic Bonds – 14.19% Foreign Bonds – 1.74% REAL ESTATE HOLDINGS: (percentage of total portfolio as of July 31, 2008) Schwab Global Real Estate fund – 6.96% PIMCO RealRetirement 2050 Fund (PFYAX) STRATEGY: “Provides dynamic asset allocation tailored to investors expecting to retire around the year 2050. Seeks maximum real return, consistent with preservation of real capital during the accumulation years and current income during the retirement years.” PORTFOLIO ALLOCATION: (as of June 30, 2008) U.S. Equity – 43.8% Global Equity – 35.2% Real Assets – 18.9% Nominal Bonds and TIPS – 2.0% REAL ESTATE HOLDINGS: (percentage of total portfolio as of March 31, 2008) PIMCO RealEstateRealReturn Strategy Fund – 15% UBS TargetRetirement 2025 Fund STRATEGY: “The TargetRetirement 2025 Fund seeks to provide varying degrees of long-term appreciation and capital preservation through broadly diversified, actively managed global securities portfolio for investors with a target retirement date of 2025.” PORTFOLIO ALLOCATION: (as of June 30, 2008) U.S. Equity – 38% International Equity – 20% Emerging Markets Equity – 3% U.S. Bonds – 18% International Bonds – 8% Emerging Markets Bonds – 2% High Yield Bonds – 3% Real Estate Investment Trusts (REITs) – 5%

Goolgasian refers to this phase in which target-date fund investors reach retirement as their "de-cumulation," which is drawing increasing focus from the defined contribution industry. Besides being the biggest source of complexity for target-date fund providers, de-accumulation also provides the biggest opportunity for investment managers to make their funds stand out, Goolgasian says. He notes that this takes on even greater importance as financial services companies try to differentiate their products in an increasingly crowded market.

Lester says these tendencies as participants near their retirement have important implications for how investors should save and how to set up their glide paths.

"One concern is that you may have too much volatility in your portfolio once you start taking these large lump sums out," she says. "What if the markets are down and you can't recover?"

Drew Carrington, UBS Global Asset Management's head of defined contribution and retirement solutions, shares this concern. Primarily, he notes that overall portfolio volatility close to retirement can have a dramatic impact on nest eggs that have taken entire careers to build.

"For individuals in a defined contribution plan, the closer to retirement, the more important the accumulated balance as compared to future contributions. You don't have enough time to make up for large losses," he says. "If you're 58, and you suffer a 20 percent decline in your portfolio, you've now impaired your standard of living in retirement permanently."

Solution: REIT-ify

First generation target-date fund managers primarily focused on adjusting equity levels to help tamp down risk. That's an overly facile approach, according to Carrington.

"Almost everybody defines the target date problem as how much equity you have at a given time," he says. "We think that's a really significant oversimplification."

Instead, Carrington is among a growing number of investment managers who are embracing an alternative solution.

"An effective way to minimize risk is to incorporate a broader range of asset classes that will have a higher probability of success in a diverse set of markets," Ruthen wrote in his 2007 commentary on target-date funds.

While plan administrators might not have many short-term solutions for curbing their participants' poor savings habits, target-date funds can take immediate action to improve diversification for the long term, according to Lester. That would mean expanding their asset mix by adding alternative investments, including REITs.

Patrick Waters, director of retirement income products for Charles Schwab Investment Management Inc., shares Lester's enthusiasm.

"A big trend has been the move to look for asset types that have lower volatility and correlation with the broader markets. There have been studies that have shown that by adding real estate into the mix, you can keep returns competitive and even bump them up while reducing portfolio volatility," Waters says. "The goal is to provide diversification exposure to smooth out performance. Real estate is definitely one of the asset types you're seeing grow in portfolios."

Evidence of this rapid gravitation toward REITs is evidenced by the findings of a Financial Research Corporation (FRC) study published in May 2008. FRC found that the number of target-date fund providers including REITs in their products more than doubled from 2005 to 2007, up from approximately one-fourth to 54 percent at the end of the two-year period.

"REITs offer diversification benefits, allowing individual investors access to institutional-type strategies," says Lynette DeWitt, research director for FRC. "In other words, investors receive the benefits of real estate exposure while not being in direct real estate investments. This allows exposure to the asset class without increasing the risk beyond the level that individual investors should reasonably accept for their retirement assets."

Both the number of target-date products holding REITs and the size of these funds' REIT allocations are on the rise, according to Kurt Walten, NAREIT's senior vice president for investment affairs and investor education. "Our conversations with the financial services community have revealed that the increased use of REITs has resulted from recognition among investment managers of the strong benefits they introduce to target-date funds, including the power of diversification and inflation protection," he says.

Carrington dismisses the notion that REITs are too similar to other equities—such as small cap value stocks—to provide actual benefits for retirement plan portfolios: "A close reading of the data shows that's not the case." He also points out that as commodity prices have bounded skyward since 2007's second half, the importance of inflation-hedging in retirement has been hammered home to investors and fund managers. Again, he says REITs are part of the solution.

"Over the short term, which is relevant for people who are near retirement, stocks are not an inflation hedge. We manage inflation risks for people who are closing in on retirement by rolling into TIPS and REITs," Carrington says.

Carrington notes that UBS maintains some flexibility in their target-date funds' REIT exposure, which enables fund managers to adjust their holdings if they feel the stocks are trading at "frothy" prices or a discount. In general, though, UBS dedicates as much as 10 percent of its target-date funds' total allocations to U.S. and global REITs.

"We think that real estate is a fundamental asset class," Carrington says. "Overall, we're fans of REITs both early and late in an individual's career."

Goolgasian says Pyramis is "very supportive" of the contributions REITs can make to target-date funds, pointing out that the securities provide income, strong correlation benefits and inflation-fighting power. He also notes that Pyramis' clients frequently inquire about the presence of REITs in the company's target-date funds. Although Pyramis' target-date funds currently have U.S. REIT allocations ranging from 1 percent to 2 percent of their total portfolios, Goolgasian says he expects Pyramis to soon start ramping up its REIT allocations in the near future.

"With REITs, you're not just bringing sand to the beach," he says. "You really have a unique investment vehicle that enhances the value of a portfolio."