The Pension Protection Act (PPA) of 2006 created two dominant qualified default investment alternatives (QDIA) for retirement plans-target-date funds and balanced funds. But even the best-laid plans can be offset by bad timing or poor execution. Most target-date funds experienced a combination of both in 2008.

The poor performance of target-date funds, particularly 2010 funds, as QDIAs has not gone unnoticed in Washington. The U.S. Dept. of Labor (DOL) and the SEC held a joint hearing on June 18 to look into how target-date fund managers determine the asset allocation of their funds. New regulations are likely from both agencies.

After a similar hearing in February, the U.S. Senate Special Committee on Aging noted that the DOL had issued regulations allowing target-date funds to be used as a QDIA in employer-sponsored retirement plans, but there were no requirements for the appropriate ratio of stocks to bonds as the fund nears its target.

A LITTLE HISTORY

A QDIA is designed to position investors in age-appropriate investments during their lifetimes. In general, this theory requires high equity exposure (higher risk and return) when the investor is younger and lower equity exposure (lower risk and return) when the investor is approaching the target date.

Ironically, prior to the PPA, industry observers felt that too many young investors had parked their 401(k) balance in cash or stable value funds and, as a result, were missing needed growth potential in their retirement portfolios. This was true in many cases, and it made sense to take action to remedy the situation. The so-called remedy was to encourage the use of balanced funds or target-date funds as defaults instead of cash funds and stable value funds. Thus, in recent years the pendulum swung from a pair of low-risk default investment products (cash and stable value) to higher-risk default investment products (target-date funds and balanced funds).

For young investors with a long investing horizon in front of them, this was a welcome change. For some older investors with only a few years separating them from retirement, the transition has been catastrophic. The issue, as always, is timing. But more than that, it also involves a misalignment between product design and usage.

Let's first examine target-date funds, since we're now within five months of reaching the first major target date: the year 2010. A significant controversy is determining what the target date represents: Is it the year the investor retires, the year he or she dies or even the year a child enters college (if the investor is targeting something other than retirement)? The answer to this question has a profound impact on the design of the target-date fund because it reflects three dramatically different ways investors might use the fund. Recognizing that investors can use a target-date fund in different ways is vital to its design.

The glidepath (or dynamic asset allocation model) in a target-date fund produces a more risky portfolio with higher return potential when the target date is far in the future, and a less risky portfolio as the target date nears. The appropriate time to begin reducing portfolio risk is within five to 10 years of the target date. Nevertheless, nearly all target-date funds fail to do so. A target-date fund that fails to protect account value as the target date approaches has failed in its primary task.

INVESTOR LIFE CYCLE

Most investors assume the target date represents the year they will retire. An investor's life cycle can be segmented into three distinct phases (see "The Game of Life," at right):

* Accumulation phase prior to retirement (ages 25-55)

* Transition phase as the investor prepares for retirement (ages 55-65)

* Distribution phase during the retirement years (over age 65).

The primary objective during the accumulation phase is to grow assets. As a result, the portfolio will consist primarily of equities until the investor is approximately 55 years old. At this time, a target-date fund should begin to protect the assets in the portfolio, while still attempting to achieve prudent growth.

In the transition phase, the target date represents the year of retirement. When an investor is 63 years old, he or she has only two years until the target date, and should be brought safely to this stage. Once safely at the point of retirement, the individual should engage in a complete financial review and make needed preparations to begin the last phase.

The distribution phase represents an entirely different experience for the individual. The investor is no longer adding new money, but is now withdrawing money from his or her portfolio. As a result, the portfolio needs to be designed differently. A target-date fund may not be the correct vehicle at this stage, or at least most of the target-date funds currently in circulation are not appropriately designed for the distribution phase.