Theories and Realities: Target-Date Funds and Modern Portfolio Theory

ERISA requires that fiduciaries, such as committee members, make their investment decisions based on generally accepted investment theories. The most generally accepted is modern portfolio theory, or MPT. For example, committee members are applying that theory— knowingly or unknowingly—when they decide on the categories of investments to offer to their 401(k) participants and when selecting target-date funds. This article focuses on target-date funds and modern portfolio theory.

However, fiduciaries also need to keep in mind that “theories” are just that—theories, but not necessarily realities. 2008 was a dramatic reminder of that truth.

In 2008, the average 2010 fund (that is, target-date funds that are designed for people who will retire in or about 2010) lost approximately 25% of its value. In other words, employees who were a year away from retirement lost a quarter of their anticipated annual retirement income from the 401(k) plan. Ouch!

How should fiduciaries respond to those losses? First, they should review the process they used to select their target-date funds, or TDFs. Fiduciaries should make sure they understand:

• the number and types of asset classes and investment categories included in the funds—and why.
• how the percentages of each are allocated within the fund—particularly over the last five or 10 years of partici­pation—and why. In other words, at this point, they should be focusing on the allocations in the 2010 and 2015 funds, and perhaps the 2020 fund.
• whether the target-date fund family is, as compared with other target-date funds of the same year, aggressive, conservative, or moderate, and whether that is appropriate for the participants in their plan.

In my experience, target-date funds are designed by skilled experts. So, in all likelihood, the “real” issue for the fiduciaries is not so much whether a target-date fund is designed properly in general terms, but whether the design is appropriate for their particular plan.

Nonetheless, fiduciaries need to understand the asset allocation structures of their target-date family and its competitors.

The ultimate output of a prudent process is one thing, and one thing alone; it is an “informed and reasoned” decision. Since ERISA requires that investment decisions be based on generally accepted investment theories, like modern portfolio theory, the process must include consideration of whether the design of the TDFs is consistent with MPT. In fact, in order for a TDF to qualify as a safe harbor default option, or QDIA, the DoL regulation requires that the TDF be based on generally accepted investment theories.

As a practical matter, most plan sponsors will need the help of a knowledgeable adviser to evaluate the asset allocation and glide path of a target-date fund family and to compare it with those of competing providers.

Assuming that you have the right category of TDFs for your employees, the next step is to compare the performance of the 2010, 2015, and 2020 funds with their peers. For example, if you have chosen an aggressive suite of target-date funds, then you should compare its performance with an aggressive benchmark.

If your plan’s target-date funds have performed in a manner reasonably similar to, or better than, the appropriate benchmark, you have done a good job of basic monitoring. On the other hand, if your target-date family substantially underperformed the appropriate benchmark, you need to ask why—and you need to get answers. Once you have those answers, you can decide whether or not they are acceptable, i.e., whether the answer satisfactorily explains variance from the benchmark. If so, your job is done—until it is time to monitor again.