New Ideas… and Shifting the Focus to Retirement Income

The TDF’s ongoing success for American savers doesn’t mean it is immune to additional evolution in both funding structures or its overall setup. In recent years, that has seen more widespread use of collective investment trusts (CITs) versus mutual funds in TDFs. With less costs devoted to the SEC registration required with mutual funds, CITs can provide lower overall operational expenses and lower participant fees, but they are not entirely free of risk, or suitable in every plan.

That’s part of a larger discussion about some of the core functionalities of the TDF, as well as an increase of awareness about the value of devoting more resources to addressing the needs of those participants now approaching or entering retirement.

“The DC landscape is constantly discussing innovation, and that’s a good thing,” says MFS’ Savage. “But the pace of innovation is not immediate (nor fast). For all the discussion around innovation, DC plans have largely established a plan investment lineup that has been streamlined over time, and includes the QDIA, the core menu consisting of building blocks for participants to create their own portfolios, and then for some, additional access to a brokerage window.”

Savage says the TDF has morphed to include a wide range of choices spanning passive and active management, plus options from recordkeepers, asset managers and custom solutions.

But Savage adds that a potential disconnect exists between how TDFs are positioned and how they are actually evaluated by sponsors. When asked what risks their TDF is intended to address, sponsors surveyed by MFS cited diversification risk (38%) and downside market risk (22%), while longevity risk—often highlighted by TDF providers as a key rationale for glidepath design, particularly for ‘through’ paths—was chosen by only 12% as the primary risk they were looking to address.

An MFS survey conducted among participants also found a lack of consensus on what to do with TDF investments once retirement is reached.

“Our survey showed that only 13% of participants plan to continue using TDFs for all their retirement assets,” she says. “The rest of the survey respondents indicated that they intend to move their assets to different investments or consult with financial advisors for guidance, highlighting that retirement is personal. These misunderstandings about the glidepath and intended actions at or post-retirement could leave participants with more risk exposure than desired at and into retirement, potentially impacting their financial security.”

Expanding the options for TDF participants approaching retirement

Wade Pfau, professor of Retirement Income at the American College of Financial Services, says those survey results reflect what he sees as one of the more pressing shortcomings of the TDF—its limited focus on post-retirement strategies for participants.

“That’s where I start to get more concerned about target date funds, regardless of whether they’re ‘to’ or ‘through’ the target date—they really just seem to be designed for the pre-retirement phase,” he says. “They’re not really thinking about funding liability for retirement—‘to’ just tends to get some sort of income fund at that date, whereas ‘through’ continues to decrease the stock allocation.”

Along with his American College counterpart, Michael Kitces, Pfau has spent the last decade championing the notion of a rising equity glide path within the TDF as an alternative risk-management strategy that could more effectively address the needs of retirees. A heavier emphasis on equity across the life of the TDF, he says, can help reduce both the probability and the magnitude of failure.

“We still agree with the pre-retirement target date … you’re aggressive when you’re young—but actually, counterintuitively, to manage retirement risk, you start becoming more aggressive in the post-retirement phase. As you get closer to the target date, some of the bond component switches to annuities. I’d also include an option, but not a requirement, to transition part of the TDF toward lifetime income.

“Ten years ago, no one had any indication that plan participants cared about reliable income in retirement,” he adds. “Now you’re seeing growth in people thinking and wanting income from their retirement plan—that’s the new mindset. So it’s going to be on the horizon for plan sponsors.”

Morningstar’s Benz agrees that more work needs to be done to shift the focus to the needs of TDF participants approaching retirement.

“Plans will be looking at the assets that many of their oldest workers have—they also have the largest balances and so the plans don’t necessarily want to see them walk out the door,” she says. “They need to simplify distribution options. Oftentimes it’s cumbersome for you to be able to pick and choose where you go for your withdrawals. I think we’ll see more plans fixing that issue to give participants more control.”

Benz says retirees also need guidance on how to handle their TDF savings and make them last.

“Participants will also need help with right-sizing their distribution. How much is reasonable to take out? I would expect to see a little bit more advice popping up to give participants guidance about safe withdrawal rates, and ancillary sources of income like Social Security,” she adds. “As always, I would expect to see the biggest plans to be the first movers in terms of adding creature comforts to their employees.”

“Many participants now see and say that the end of my working career is not the end of my investing career—I could be holding an account and managing income for another 30 years in retirement.

ICI’s Sarah Holden

ICI’s Holden anticipates that the biggest innovations in TDF plan design will likely come as more and more workers find themselves looking for a systematic withdrawal plan as they approach retirement age.

“We’ve got a whole bunch of folks who have been in this system for quite a while. How do we transform the huge success of accumulation to a successful spend-down, or get myself a paycheck in retirement?” she asks. “Some providers are putting a sleeve into the TDF that gets you bits of an annuity. Other providers say they’ll make an asset pool that’s going to generate that paycheck.”

More importantly, she says that plan sponsors need to recognize that the TDF is just part of the overall retirement planning solution, and that offering participants advice and options for more actively managed accounts might not be such a bad thing, either.

“Many participants now see and say that the end of my working career is not the end of my investing career—I could be holding an account and managing income for another 30 years in retirement,” Holden observes. “So we see a bit more attention now paid by older participants. They have a bigger account now, and they realize they need to think about that more now. And they do actually take the reins and do a more personalized asset allocation.”

The future role of TDFs in 401(k) plans

Given their two decades of status as the reigning QDIA of choice, it’s unlikely the target-date fund will be usurped by any new retirement-savings mechanism. And given recent market and economic volatility, the security and relative simplicity of the TDF continues to offer millions of participants a better chance for a long and prosperous retirement.

Morningstar’s Benz says TDFs may not be the most revolutionary savings vehicle, but in a world where most participants aren’t interested in actively managing their own portfolios, the TDF has been instrumental in helping people save. At the same time, she says, it offers some flexibility to allow those who’d like to take a more hands-on approach.

“It’s just been a slow but steady success story for TDFs,” she says. “We see that 401(k) participants, writ large, are generally pretty inert; they don’t make a lot of changes. There is a lot to be said for simplifying this. If they want to do something else with their funds, plans offer that option—most have a brokerage window if you find attracted to investments outside of the plan menu. So there’s an escape hatch for people who feel the need to do something different.”

Like any employee retirement benefit, the critical part is encouraging participants to take part and make the effort to accumulate enough to make retirement work on their own terms. With or without plan design tweaks, the TDF’s success suggests it will continue to be a mainstay of the 401(k) environment.