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The future of investing
By Rob Wherry

SmartMoney - 1 September 2006
(c) 2006 SmartMoney. All rights reserved.

Congress is considering a radical change to 401(k) plans that could increase savings and returns. Too bad fund companies can't agree on the right investments.

For two years Thomas Fontaine, a sandy-haired computer science Ph.D. and senior portfolio manager at AllianceBernstein, pored over spreadsheets in his nondescript 41st-floor office in midtown Manhattan. He studied reams of data on life expectancies, saving habits and historical stock market performance. His modest goal: to revolutionize the way Americans invest for retirement.

Fontaine's work is focused on a relatively new type of mutual fund designed for retirement accounts called target-date, or life-cycle, funds. These funds invest in a combination of stocks, bonds and other assets; what differentiates them is that they grow more conservative as investors age. And in a widely read report based on his findings, Fontaine argues that most existing target-date funds miss the target when it comes to asset allocation. In a second body slam to the industry, Fontaine says most funds are way too expensive as well. The bottom line: The wrong mix of assets in an overpriced fund could cost an investor hundreds of thousands of dollars by the time he retires.

Fontaine is not the only person who is zeroing in on target-date funds. Lawmakers are also weighing in on the issue, and a measure that may come up for a vote by September could transform retirement investing as we know it. A six-sentence provision buried deep in the 450-page pension-reform bill would open the door for employers to automatically enroll new employees in 401(k) plans and make target-date funds the default option. "This is one of the few issues that has broad support on both the left and the right," says Matt Moore, a senior policy analyst with the National Center for Policy Analysis.

Why is this a big deal? Under the current system, an employee who does nothing has no retirement plan -- and an awful lot of people do nothing. According to Hewitt Associates, more than half of eligible employees between the ages of 20 and 29 take a pass on enrolling in 401(k) plans, and nearly a third of thirtysomething workers haven't bothered to sign up. Among those who do, many stash their cash in safe, low-yielding bonds and money-market funds, though their retirements are decades away.

Even if that's not you-and if you're reading this magazine, it probably isn't-these proposed changes could have a big impact on your finances. According to AllianceBernstein, hundreds of billions of dollars in new money could flow into the stock market over the next 10 years if target-date funds do indeed take hold, and that steady inflow of cash could help support stock prices for decades to come.

With so much money at stake, even small differences in the way life-cycle funds invest could have a huge impact on a retiree's financial well-being. So you would think that funds designed for people who plan to retire in, say, 2030 would be pretty much in agreement on how that money is spread out between stocks and bonds. Think again. T. Rowe Price's Retirement 2030 fund is 93.5 percent invested in stocks, while Barclays Life Path 2030 fund thinks 78 percent in equities is the right mix for a 40-year-old retirement investor. The difference in those two assumptions could be enormous. According to one of Fontaine's calculations, a typical retirement portfolio that starts with 90 percent of assets in stocks and then scales back to 65 percent by retirement could add up to as much as $2.5 million after 40 years of saving. A similar portfolio that starts with 70 percent in equities before recalibrating could be worth $1 million less.

What's more, there's a case to be made that mutual funds, which have traditionally been the backbone of 401(k) plans, may not be the best vehicle for target-date funds. Most life-cycle funds are funds-of-funds, meaning their portfolios are divided up among several separate mutual funds, usually within the same family. The Putnam Retirement Ready 2030 fund, for example, comprises six other funds, giving investors exposure to U.S. and international stock markets as well as cash and bonds. And those funds are the same ones that fund companies sell to retail investors, meaning target-date investors are paying retail prices for what is effectively a wholesale account. For example, Putnam's Retirement Ready fund charges annual fees of 1.37 percent of assets, or $137 a year for every $10,000 invested. Fidelity's Freedom fund, meanwhile, charges $79, while Seligman Time Horizon nicks investors for a whopping $221 per $10,000. Fontaine argues that 401(k) investors are getting a raw deal, and that life-cycle portfolios should not be invested in retail funds but ought to be run like pension-fund money -- complete with fees as low as $18 per $10,000. (Vanguard, it should be noted, charges just $20 per $10,000 for its Target Retirement portfolios, which are invested in index funds.) Alliance-Bernstein, of course, does have a dog in this fight. The company already manages $400 billion in pension money and hopes to get some of the business if Congress changes the law and target-date funds take off.

Fund companies counter that the pension analogy isn't perfect -- 401(k) investors expect a prospectus and individual statements, for example, which cost money. But they aren't dismissing Fontaine's argument either. "This is like institutional investing," acknowledges Jonathan Shelon, head of Fidelity's Freedom funds, in that there's a nearly infinite time horizon. And competitive pressures are driving expenses down. Last year, for example, Fidelity stopped charging the 0.08 percent annual premium it added on top of its life-cycle funds.

Even without any change in the law, target-date funds are a big business -- assets have ballooned 50 percent a year since 2001 and now exceed $89 billion. Fidelity manages half of those dollars, while the rest is divided mainly among Principal, T. Rowe Price, Vanguard and Barclays. American Century even signed up legendary cyclist Lance Armstrong to pitch its new life-cycle funds. But if the auto-enrollment measure is passed by Congress -- and Washington insiders say it's a question of when, not if -- the amount of money flowing into these funds will increase dramatically. "It would seem like Congress is helping out the mutual fund industry, because there will definitely be more assets," says Gilbert Mateer, president of retirement services at Bryn Mawr Trust. "But the critical point is that people aren't saving enough. If plans are put on autopilot, savings will increase."

Though target-date funds would seem a marketer's dream, the concept actually originated with a group of economists who were trying to figure out ways to encourage savings. The most effective way to get employees to participate in a 401(k) plan, they found, was to make inertia a force for good: Instead of requiring them to sign up, participation becomes the default option, and employees are given the chance to opt out. That simple change, according to one oft-cited study, is enough to make enrollment rates nearly double. But that's just the first step. Workers must also contribute enough money and invest it wisely. Richard Thaler, a noted professor of behavioral science and economics at the University of Chicago, has found a way to address both concerns. Thaler found that savings levels jumped when companies convinced employees to agree to automatically increase their contributions whenever their pay increases. Since their paychecks never shrink, but simply grow by less, the employees never suffer sticker shock.

And one way to get people to make better investment choices, Thaler told SmartMoney, was to offer fewer, not more, funds in retirement plans. Too many choices "can flummox less sophisticated employees," he says, and a diversified portfolio like a life-cycle fund is a good default option. As he told a congressional committee, "By incorporating simple lessons of psychology and a little common sense about human nature, it is actually quite easy to help Americans save."

Thaler's findings are hardly controversial, but the decision on what constitutes a proper mix of stocks and bonds is. Fontaine's report, published in October, comes to a radical conclusion. To account for longer life expectancies and soaring health care costs, he argues that investors need more growth than most funds provide and proposes that investors keep a majority of shareholder assets exposed to stocks until they are in their early 70s, an aggressive-and almost unheard of-posture. "We would argue a more conservative approach is actually the riskier one," says Fontaine, explaining that the biggest risk is not that retirees will lose money in the market, but that they will run out of money before they die. Almost every major fund family has since followed his lead to some extent or is contemplating making similar moves.

"This is something that's just happened over the past 180 days," says Doug Grove, who oversees life-cycle funds at Principal Financial Group. For example, Vanguard recently increased the stock allocation in its 2025 fund to 82.5 percent from 60 percent, and in March, Fidelity announced it was boosting the share of stocks its target-date funds will hold after investors retire. Others, however, believe the money-management industry has overreacted. "Our view is that the revisions taking place on the back end of these funds are rather risky," says Jeffrey Knight, a chief investment officer and asset-allocation specialist at Putnam. Putnam's life-cycle funds hold just 25 percent of assets in equities during retirement.

So what should individual investors do if they want to put their retirement savings on autopilot? Since most 401(k) plans offer target-date funds only from a single fund family, you probably are not in a position to choose among different offerings (though IRA investors -- and more than half the $3.7 trillion in IRAs comes from 401(k) plans that have been rolled over -- do have a choice). Instead, check the expense ratio. If it is high -- anything over 1.2 percent is pricey -- consider diversifying on your own by investing in a mix of index funds. Of course, that requires more work than just going on autopilot, and if you're not interested in monitoring and adjusting your investments, a life-cycle fund is a better bet.

The other consideration is asset allocation. Given the wide disparity in stock allocations, you'll have to do a gut check: How much volatility can you handle? A 40-year-old in the T. Rowe Price fund, with 93.5 percent in stocks, is signing up for much more of a roller-coaster ride than the Barclays investor. For instance, if an investor had put $100,000 in a fund with a mix similar to T. Rowe's in 1995, it would have increased to as much as $223,000 in 2000, only to shrink to $163,000 by 2002. In contrast, a portfolio with a mix similar to the Barclays 2030 fund would have doubled, to $204,000, by 2000, but would have fallen back to $169,000 by 2002. By the end of last year, however, both funds would be worth virtually the same amount -- $239,000 -- and investors who had been steadily putting away money in a T. Rowe-style allocation would now be on top.

If your only choice is a fund that seems too aggressive, one way to smooth the journey would be to allocate 90 percent of your money to the life-cycle fund, then put the rest in a stable-value fund. Such individual tweaking violates the autopilot spirit of target-date funds, but if it will keep you from panicking, it may be worth it. The reverse also works: An investor in a conservative life-cycle fund who wants more growth might keep 10 percent of his 401(k) holdings in, say, a total stock market index fund.

For most retirement savers, however, choosing a target-date fund is a one-decision investment. Take the 450 employees of the Sentry Group -- a Rochester, N.Y.-based manufacturer of safes. Nine out of 10 employees who contribute to the firm's 401(k) put their money in a Manning & Napier life-cycle fund. "We wanted to give our employees a vehicle where the decision-making process was done for them," says Kathy DeCann, Sentry's compensation and benefits manager. "They don't have to worry."