For over a decade, all-in-one investments such as 529 plans and target-date funds have provided a simple way to save for college or retirement and allowed financial advisors to serve smaller clients cost-effectively, consolidate assets and free up time to focus attention on financial planning and tax matters. But the recent market setback shows that such simplicity comes at a cost, as advisors have little or no leeway to adjust positions in these vehicles and make changes when the market is melting down.
Shrinking account size is not limited to packaged investment products, of course. With the markets falling en masse in 2008, even some of the most carefully crafted and custom investment portfolios have been hit hard and may be doing no better.
In traditional investment accounts, financial advisors were at least able to help clients work through the massacre by tax loss selling, hedging, repositioning portfolios, making tactical overlays and adjusting withdrawal rates on retirement plan distributions. But the ability to make such adjustments and maintain control is much more limited in packaged products. These funds typically begin with a specific asset allocation mix that gravitates to a more conservative stance as it moves toward a "launch" event such as college or retirement. At this point, many investors who are about to begin tapping into these funds for college expenses or retirement are finding a dwindling cache at a time when they need it most.
Degrees Of Pain
The impact on the funds depends largely on the asset mix at the time investors are supposed to begin taking withdrawals from the accounts. Just before the recent election, some age-based 529 plans designed for those a year or two away from college had 40% or more of their assets in stocks. With about half of its portfolio in stocks, including real estate securities, the North Carolina National College Savings Program's CollegeHorizon Funds was down more than 25% year to date through October-a tough pill to swallow for cash-strapped parents facing tuition bills in a few months.
The programs with lower stock allocations, earmarked for those who were a year or two away from college, held up better. Fidelity's Arizona 2009 College Plan lost only about 8% over the same period, and a comparable Vanguard fund, which had about 25% of its assets in stocks, was down only 11%.
Marty Urbanowicz, a financial advisor with Rock Martin Private Wealth Management in Peoria, Ariz., says that some of the age-based 529 plans are too heavily invested in stocks. He believes that a portfolio for someone a year or two away from college should not have any money in equities at all, particularly if it is the major source of the student's funding.
Gary Carpenter, a financial advisor in Syracuse, N.Y., and co-author of College Financial Planning For Any Income Level, agrees that some of the 2010 plans have invested too aggressively. "If you're a year away from college you need to be in highly liquid securities such as certificates of deposit and have little or no exposure to the stock market," he says. When Carpenter uses 529 plans, he typically combines them with other investments so that they are not expected to provide for more than one year of college costs. "You don't want to have all your eggs in one basket, especially if a child is starting college during a bear market," he says.
Another type of 529 allows account owners to change investment strategies, choosing among several differing types of investments. But the IRS limits you to only one change in investment strategy per year, a rule that has made it difficult for individuals to adjust rapidly to severe market changes. Urbanowicz says that despite that restriction, he uses these types of plans for some clients because of their tax advantages and the greater flexibility and discretion they afford him over other age-based plans.
Returns Off Target
Assets in target-date funds, which have become a staple in 401(k) plans and an increasingly popular choice among both individuals and financial advisors, have also been severely eroded in the recent market turmoil. Many of the 2010 funds that retirees are expected to draw on next year have seen drops that could well force many of them to put retirement plans on hold or lower their standard of living.
The equity portions of these portfolios, which typically drop from about 50% to 60% of assets when a person retires, have been hit hardest. Ron Surz, principal of Target Date Analytics in San Clemente, Calif., argues that the allocations in target-date funds are too aggressive. In a report issued by his firm in late October, Surz said that target-date companies want to hang on to assets beyond the accumulation phase, and do so by keeping equity allocations high and extending the asset allocation "glide path" well beyond the target date. The report says the target-date funds should instead "be entirely in safe, non-risky assets at target date, waiting for the participant to move to the next phase."
"Target-date funds are a great idea with awful execution, at least so far," Surz concluded.
According to a report earlier this year by Watson Wyatt Worldwide, equity target allocations in target-date funds show considerable variation across a broad range of expected retirement years, with equity allocations in the funds on retirement day ranging from 20% to 65%. Another report from Financial Research Corporation (FRC) found that at the end of 2007, the average target-date fund had 68% of assets invested in stocks, an increase of 13 percentage points from five years earlier.
Lynette DeWitt, research director at FRC, says that the increase in equity allocations came in response to investor demand for competitive returns, and that the funds face criticism if they are underexposed to equities during bull markets. Still, she believes the latest bear market, the first that many of these new funds have had to face, could prompt sponsors to retool their offerings. "There has been more interest in having stable value as an investment option and more attention to looking at downside risk," she says. "I know of at least one fund company that plans to decrease the equity allocation in its target-date funds."
At this point, though, the stock market swoon has left its footprint on some of the most popular offerings with near-term target dates. T. Rowe Price's 2010 offering was down 25.48% year to date through October, somewhat better than the drop of 32% by the S&P 500. The fund had 57.5% of its assets in equities as of September 30, its most recent reporting date. With just over 47% of its assets in stocks, Fidelity's 2010 offering fell 23.72% over the same period. As of early November, the Oppenheimer Transition 2010 fund, which reported a 63% exposure to equities as of September 30, was down nearly 35% year to date.
Managed payout funds, another packaged retirement solution and a close cousin to target-date funds, have also suffered. The Fidelity version of the funds allows investors to receive regular monthly payments consisting of return of principal and earnings until a specified date, when the account is emptied.
Vanguard's three managed payout funds also have a check-a-month feature. The three funds, which differ from the Fidelity offering because they are designed to distribute income while leaving something on the table for heirs, anticipate respective annual distribution rates of 3%, 5% and 7%. Both the Vanguard and Fidelity versions adjust payments each year based on investment returns in the accounts and other considerations, and they provide no income guarantees.
The problem with managed payout funds is that with falling asset values, management firms have relied mainly on principal rather than account earnings to keep monthly distributions on an even keel in 2008. The Vanguard Managed Payout Growth Portfolio, which has a 3% distribution rate, had 88% of its assets in stocks at the end of the third quarter and had fallen 30% in the six months from its inception in May 2008 through October 31. The more conservative Distribution Focus Fund was down 26% over the same period and had 73% of its assets in stocks. The Fidelity Income Replacement Fund 2016, designed to pay out all its assets that year, had fallen nearly 18% year to date at the end of October, while the more aggressively invested 2030 fund was down 25%.
Fund companies say the asset allocations and withdrawal rates of target-date funds and managed payout funds are based on well-researched models geared to addressing longevity risk, and that investors need to take a long-term view instead of focusing on recent drops. And despite the firms' hands-off policies, there is some room for maneuvering. With managed payout funds, for example, investors can turn the payment spigot off an unlimited number of times during market downturns or at other times without charges or penalties. To get around the restriction to once-a-year investment changes to 529 plans, someone could change plans or switch beneficiaries.
Nonetheless, the recent issues with plug-and-play investment solutions have reinforced the notion that the financial advisors who use them should be aware of their diverse investments and asset allocation strategies, and should monitor their performance periodically. "If someone hires you as an advisor, it's wrong to just put a check mark next to something that manages itself and forget about it, even if it's a small account," says Urbanowicz.