By John M. Miller, CFA
Use of “passively” managed target date funds in 401(k) plans is on the rise. Why is this? Most would suggest that the primary driver is lower fees. I tend to agree. However, fees are only one component of investment value. Risk management is another. In an investment world likely characterized by lower returns and increased volatility, the importance of risk management in achieving successful retirement outcomes will grow.
People saving for and nearing retirement cannot afford to be blind to the dangers embedded in passive target date funds — especially the risks associated with allocations to passively managed fixed income. Keep in mind that fixed income becomes a growing part of a target date portfolio as one nears retirement. A review of publically available data for a wide variety of target data funds shows that 10 years from retirement, the average target date fund will allocate approximately 40% of its assets to fixed income; at retirement, when your account balance tends to be the largest, that figure rises to over 60%.
So what does this mean if you have a significant portion of your target date assets allocated to index funds investing in fixed income? Three things: low yield, risks of the index, and no active risk management. Let’s take a closer look.
First, prepare to accept the low yield offered by your typical index. The Federal Reserve has lowered interest rates to nearly zero and has taken additional steps to lower the yields on Treasury and mortgage bonds through massive monthly purchases. Currently, the yield on the 10-year Treasury sits at around 1.9%. Those near retirement should be rightfully concerned that such a paltry return will not keep up with the rate of inflation.
Risks of the Index
Second, you will be exposed to the risks of the index. Interestingly, the subtle message of passive target date fund providers is that they are low risk. This is not necessarily true. Consider the way virtually every bond index is constructed: The more that a government, an agency or a company borrows, the greater weight they are given in the index. Said another way, an investor in a passively managed bond fund will have increasing exposures to those borrowers whose indebtedness is increasing and whose credit worthiness may be declining … a la Greece, Japan and now the United States. Indeed, the U.S. government has become a larger component of the Barclays Aggregate Bond over the last decade as we have increased our borrowing. Government bonds now account for nearly 45% of this index at a time when rates are at historical lows.
No Active Risk Management
Third, investing in passively managed bond funds means no active risk management. We know that investors are concerned about rising interest rates. However, this key concern receives no attention in index funds precisely because these funds assume that the duration (interest rate risk) of the index is appropriate in all market environments. Interest rate risk, as well as many other forms of risk, needs to be actively managed.
John M. Miller, CFA
Investors in target date funds can do better than passive. In fact, they must
do better, from the perspectives of both return and risk. Accepting the embedded risks of index funds is not the best choice. Part of the real and demonstrable value proposition of actively managed funds is active risk management.
Actively managed fixed income funds are not likely to have the lowest fees. Look to passive funds for the lowest fees possible. But beware: You just might get what you pay for.
John M. Miller, CFA, is a managing director in PIMCO’s Newport Beach office, an account manager, and head of PIMCO’s U.S. retirement business. Prior to joining PIMCO in 1999, he was an officer in the U.S. Army, achieving the rank of captain. He has 14 years of investment experience and holds an MBA from Harvard Business School and an undergraduate degree from the United States Military Academy, West Point.
This article contains the current opinions of the author but not necessarily those of PIMCO. Such opinions are subject to change without notice. This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission.