Robert Arnott's recent criticism of target-date fund strategies is an "unfortunate" analysis that misses fundamental points, says Folio Investing's CEO Steven M.H. Wallman.

In an article Arnott release last week entitled "The Glidepath Illusion," Arnott said it makes intuitive sense to hold fewer equities the closer one gets to retirement, but that's not the best strategy for maximizing retirement assets. When his firm tested the glidepath premise, it concluded that investors have a better chance of a bigger retirement portfolio if they follow an "inverse glidepath," moving more money into equities in the last decade before retirement.

Wallman said in an interview that it's obvious a person who raises the percentage in high-risk assets after accumulating more savings has a better chance of ending up with a larger portfolio.

But Arnott misses the whole point of a target-date retirement-type offering, which gives someone who saves throughout her working career the chance to reduce the riskiness of equity-based investments over time, Wallman says. "As you get toward the end of that working career, you don't have the opportunity to make up for riskiness in an equity-based investment," he adds. "In order to preserve the wealth that's been accumulated, you need to reduce the risk level."

Others agree. "The fact is TDFs should end in very safe assets, like short-term TIPS and T-bills, rather than bonds or stocks," says Ron Surz, president of PPCA Inc. and its division Target Date Solutions, which designs target-date funds for retirement plans, in a recent article. "The need for stability and predictability is critical as retirement nears because that's when retirement plans are made, when future lifestyles are dreamt about and finalized. Bonds are not safe investments; neither are stocks."

An investor with a bigger retirement account who has too much equity exposure will lose more money than someone with a smaller portfolio if the market dives, as it did in the 2008 financial crisis, Wallman notes. "We saw what happened when you had some of the riskier target-date funds that did not end up being as risk-controlled as they should have been failing in the 2008-09 time frame with people who were retiring," he says. "They had incurred far too much risk for somebody close to retirement."

That 2008 scenario illustrates what Wallman believe is a design flaw in many target-date funds: They follow an asset-allocation glidepath instead of a risk-budgeted glidepath.

Target-date funds "are getting better diversified and more thoughtful in their approach, but in many cases they still seem to be relatively and consistently underdiversified," maintains Wallman, whose firm offers target-date folios customized to an investor's risk tolerance.

Many target-date funds benefit from market run-ups, but still don't provide much protection when the market is going down, he says. "The point of being well-diversified is to mitigate those asset-class specific risks, and what we have seen is that an awful lot of target-date mutual funds combine S&P 500-type investments with investments that are basically large-cap U.S. issuer bonds. Those two asset classes are very, very highly correlated, almost around 99 percent," Wallman says.

Target-date funds, Wallman says, should include a wider variety of asset classes, such as commodities, real estate, emerging markets, small caps, TIPS, Treasuries, and even munis, which turn out to have a very low correlation with the other asset classes. "People would say, 'How could you put a muni in a retirement account?' and the answer is in terms of yields and actual diversification benefits, munis can make a lot of sense," he says.

Why haven't more target-date funds included a broader variety of investments? Wallman says mutual fund companies like to include funds from their own families in target-date funds, but they may not have broad enough asset-class choices. Also, funds with commodities or emerging-market securities tend to have higher expense ratios, which can be more difficult to justify. Their diversification benefits can be harder to quantify and demonstrate on a computer screen, Wallman says, so it becomes easier to go with the least expensive offerings even if diversification suffers.

Lastly, when target-date funds were first introduced, the intent was to make them simple, Wallman says. "Once they became part of the qualified default investment alternative for opt-out 401k plans and people started having their money invested in them without focusing on what the investments were, I think there was an obligation on the part of the industry to design them a lot better, but there's an inertia that said, 'We've got them, they seem to be working," and then offer what we've already had out there," he says.

Keeping funds simple and cheap are good goals, he said, but design flaws in target-date funds still need to be corrected.

-Dorothy Hinchcliff