Morningstar Ratings of Target Date Funds are Obsolete
Free Target Date Fund Prudence Ratings
Investment fund ratings rely heavily on investment performance. Such is the case with Morningstar’s ratings of target date funds. But the fact is that high TDF returns over the past five years are an indication of imprudent risk taking. In this article we develop a new rating that measures the prudence of TDF glide paths rather than performance. Fiduciaries face possible legal action for imprudent TDF selections. Morningstar ratings punish our measure of prudence.
The three great benefits of target date funds are diversification and risk control provided at a reasonable cost. All three of these benefits vary widely across target date fund providers. We examine each benefit in the order of its importance.
The most important, and prudent, benefit is safety at the target date
As you can see in the following graph, only a handful of TDFs provide true safety at the target date.
The second most important benefit is reasonable cost
Fees undermine investment performance and are the basis for several successful lawsuits. You can be the judge of what is reasonable, keeping in mind that you want to get what you pay for. The challenge for plan providers is achieving good diversification for a reasonable cost. Assets that diversify, like commodities and real estate, are expensive.
As shown in the following graph, only a handful of TDFs are low cost, similar to the scarcity of TDFs that provide safety at the target date. You need to ask yourself what you get for a high fee that you can’t get for a much lower fee.
Diversification is the third most important benefit
“A picture is worth a thousand words.” Diversification is readily visualized as the number of distinct asset classes in the glide path, especially at long dates. The following are examples of well diversified TDFs, as seen through the lens of PIMCO’s Glide Path Analyzer. Think “A rainbow of colors is diversified.”
To summarize, some TDFs provide good safety, while others provide broad diversification, and still others provide low fees. To integrate these three benefits we’ve created a composite Prudence Score. The graph on the right shows the Top 20 Prudence Scores and compares them to Morningstar Ratings.
We hope you find these Prudence Scores helpful. We also hope that plan fiduciaries will vet their TDF selection. The fact that more than 60% of TDF assets are with the Big 3 bundled service providers suggests that fiduciaries are not considering alternative TDFs, so participants might not be getting the best; they’re simply getting the biggest.
Many thanks to PIMCO for letting me use their Glide Path Analyzer. It’s great. That said, the views expressed in this report are strictly my own.
Disclosure: I sub-advise the SMART Target Date Fund Index that is included in this report. It’s treated exactly the same as all the other funds.