Sunday, January 27, 2008

Target Retirement Funds - Home Squeezed or Heart Healthy

The Target Retirement Fund is a recent investment product innovation that fulfills a basic need for a simple, professional lifecycle driven asset allocation for uninvolved investors. It promises to provide a healthier financial retirement. From a marketing and product development perspective, an analogy can be drawn to a basic consumer commodity…orange juice. The primary virtue of orange juice is its high vitamin C content which helps the body fight infections like colds and is essential for tissue repair as well as wound and bone healing. It promises to provide a healthier physical lifestyle.

For both products, innovation in product development and marketing is a key factor in driving sales and revenue for the seller. The differentiation of products (target retirement funds or orange juice) by key features and minor details is an important strategy by which sellers both promote their brand and defend their fees. Yet these innovations may have limited realizable marginal benefit for consumers while in aggregate substantially complicating their selection decision making.

In selecting and evaluating Target Retirement Fund’s, fiduciaries are effectively faced with a “walk down the orange juice aisle” where product selection has become impossibly complex due to the phenomenal growth of brand extensions. For instance, Tropicana alone offers these choices; Original with No Pulp, Homestyle with Some Pulp, and Grovestand with Lots of Pulp. Calcium + Vitamin D with No Pulp, Grovestand (Lots of Pulp) with Calcium, Organic Orange Juice, Orchard Medley, Fiber, Low Acid, Healthy Heart, Healthy Kids, Antioxidant Advantage, Light n Healthy with Calcium, Light n Healthy with Pulp and others.

Target Retirement Funds are offered under different brands by competing firms. They fulfill the same basic need but typically do not have identical features. The differential features of Target Retirement Funds include their; core asset allocation and asset class diversification, equity glide paths and the investment structure by which the funds are implemented (active vs. passive investments, proprietary vs. sub-advised managers).

Because of the substantial variation in how Target Retirement Funds can be developed and implemented, it has been difficult to establish general standards and benchmarks by which fiduciaries can objectively measure the value of each fund’s distinctions. The industry is focused on this question and at least several firms have addressed the Target Retirement Fund benchmarking. Capital Group and Vanguard both offer some alternative thinking on approaches. An obsession with developing the perfect Target Retirement Fund benchmark can be somewhat academic however.

Given the single age based risk parameter and average investor assumptions upon which these funds are based; intrinsic investment uncertainty and the relevance and dispersion of individual investor circumstances probably far out-weight any additional ex ante performance improvement that can be developed via a better benchmarking process. Target Retirement Funds can be a good investment solution for everybody but can never be a perfect ex post investment solution for anybody, regardless of how well they are constructed.

While random selection is perfectly acceptable in the orange juice aisle, it is not quite that simple for fiduciaries selecting Target Retirement Funds. However, by following some basic selection criteria, (such as reviewing funds from reputable firms, with low costs, good asset class diversification and a reasonable equity roll down), fiduciaries should be able to avoid the investment equivalent of a Sunny Delight.

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