Despite their growing popularity, currently exceeding $1 trillion, there’s a lot of confusion surrounding target date funds. There are certain characteristics that matter more than others, and retirement plan advisors should focus on the most important. For instance:
- “Doesn’t Matter at All” Category: To-versus-Through, Demographics, Open-versus-Closed
- “Matters a Little” Category: Tactical, Active or Passive, Collective or Mutual Fund
- “Matters a Lot” Category: Price, Diversification, Risk control
We’ll examine each in turn.
Doesn’t Matter at All
Largely due to the DOL’s 2013 TDF Tips, most pundits, including prominent ERISA attorneys, believe the two most important considerations in choosing a TDF are “to-versus-through” and demographics. This is simply not true.
A “to” fund ends at the target date, whereas a “through” fund is a target death fund. But the reality is that most participants withdraw their accounts at retirement, so all TDFs are de facto “to” funds. Also, the common belief is that “to” is safer at the target date than ”through”, but this is incorrect since many “to” funds are riskier at target than many “through” funds.
As for demographics, the DOL tells fiduciaries to consider “participation in a traditional defined benefit pension plan, salary levels, turnover rates, contribution rates and withdrawal patterns.” This is an unreasonable mandate for a one-size-fits-all vehicle. As a practical matter, our sole focus should be on those who default their investment decisions, since most assets in TDFs are there by default. The one demographic that all defaulted participants have in common is lack of financial sophistication, which argues for safety first.
Open-closed architecture is the third characteristic that doesn’t matter. In its 2014 Target-Date Series Research Paper, Morningstar shows that the performance of open TDFs is about the same as that of closed TDFs, despite the common belief that “open” is better.
Matters a Little
The same Morningstar report concludes that there has been a modest performance edge in tactical funds and in Passive over Active.
Although it’s not discussed much, collective investment funds (CIFs) have a couple advantages over mutual funds. CIFs can be provided on a more cost effective basis because overhead costs are lower, and CIFs stand as fiduciaries to the plan, whereas mutual funds do not.
Matters a Lot
My recent article in 401(k) Specialist identifies the three characteristics that matter most. The benefits of target date funds are diversification and risk control, and both come (or should come) at a reasonable price. All three of these benefits vary widely across target date fund providers. Some funds are good at one or two of these benefits, but only a handful are good at all three.
Diversification is important at long terms to target date where we see consensus in high equity allocation, so the differentiator is diversification, i.e. combining different types of equities. Theory states, and evidence confirms, that diversification improves the risk-reward profile of a portfolio.
Near the target date we see wide disagreement across TDFs, with equity allocations at target date ranging from a high of 70% to a low of 20%. The prudent choice is safety at the target date.
These benefits are prioritized as follows:
- Risk control matters most.
- Fees are second in importance.
- Last but not least is diversification.
A lot of time and energy is wasted on things that don’t matter in TDFs. Even worse, bad decisions are made for misguided reasons. I hope this column helps.
Most importantly, I hope that fiduciaries will vet their TDF selection. More than 60% of TDF assets are with the Big 3 bundled service providers. Big is not better in TDF land.
Ronald J. Surz is president of PPCA Inc. and Target Date Solutions in San Clemente, California. Target Date Solutions developed the patented the Safe Landing Glide Path®, the basis for the SMART Funds® Target Date Index collective investment funds on Hand Benefit & Trust, Houston, the only investable target date fund index. Ron is co-author of the “Fiduciary Handbook for Understanding and Selecting Target Date Funds.“
With more than 20 years serving financial markets, John Sullivan is the former editor-in-chief of Investment Advisor magazine and retirement editor of ThinkAdvisor.com. Sullivan is also the former editor of Boomer Market Advisor and Bank Advisor magazines, and has a background in the insurance and investment industries in addition to his journalism roots.
