The Ideal Glidepath for Target Date Funds

The $3 trillion target-date fund (TDF) industry has no official standard, but the de facto standard is the Big 3—Vanguard, Fidelity, and T Rowe Price—because they collectively manage 65% of the assets. But a recent Congressional inquiry questions this standard and specifically asks why the TDF of the Federal Thrift Savings Plan (TSP) is so different in its safety at the target date. The TSP is the largest defined contribution plan in the world, with $770 billion and 6 million beneficiaries.

The Big 3 TDFs end 90% in risky assets at the target retirement date (55% in equities plus 35% in risky long-term bonds), while the TSP ends less than 30% in equities and bonds, with the remaining 70% in safe government-guaranteed funds (the G Fund).  It’s also noteworthy that the expense for the TSP TDF is only 5 basis points (.05%).

A new standard

TSP’s TDF should be the fiduciary standard for all TDFs, and particularly union TDFs, because of its emphasis on protecting beneficiaries, especially near the target retirement date.  TSP is not alone. Similar glidepaths are being followed by the SMART TDF Index collective investment funds and the Office and Professional Employees International Union (OPEIU) National Retirement  Savings Plan (NRSP), one of the larger AFL-CIO unions.

This trio sets a prudence standard that is critically different from the Big 3 standard and is most appropriate for union plans. The  Big 3 is a Procedural Prudence Standard because most plans currently use these TDFs. The TSP Trio sets a Substantive Prudence Standard by protecting beneficiaries; in other words, doing what is right. The differences between the two standards are caused by disagreements about the objectives of TDFs as discussed below.

The Big 3 standard evolved from a selection process that favors the plan’s bundled service provider for its familiarity and convenience, leading to the current oligopoly. The Big 3 glidepaths were assumed to be alright until this Congressional inquiry questioned them.

Congressional Inquiry

On May 6, 2021, Senator Patty Murray (D-WA), Chair of the Health, Education, Labor, and Pensions (HELP) Committee, and Rep. Robert C. “Bobby” Scott (D-VA), Chair of the House Education and Labor Committee, sent a  letter to Gene Dodaro, Comptroller the GAO, seeking answers to 10 questions dealing with concerns that some aspects of TDFs may be placing American retirement savers at risk.  The first none questions are informational. The tenth question asks for a recommendation:

What are possible legislative or regulatory options that would not only bolster the protection of plan participants, who are nearing retirement or are retired, but also achieve the intended goals of TDFs?

And the letter also asks the GAO to explain why the TSP TDF is so different:

One 2020 TDF, which has over $16 billion in assets, is reportedly 60 percent invested in stocks.  Meanwhile, the Thrift Savings Plan’s (TSP’s) 2020 Lifecycle Fund, which was retired in July 2020, had more than 60 percent allocated to its G Fund (short-term U.S. Treasury securities) for the two years prior to its retirement.

Investment risk

There is no investment risk when markets only go up as has been the case for most of the past 13 years, but there have been two tests of risk mitigation in TDFs — 2008 and February-March 2020. As shown in the following graph, the TSP Trio has defended well in the face of market corrections while the Big 3 has not:

The differing risk exposures at the target date reflect differences of opinion about the appropriate objectives for TDFs.

TDF objectives

DOL guidance says TDFs should be chosen based on the demographics of the workforce. This guidance should more appropriately be directed to the demographics of defaulted beneficiaries since most TDF assets are those of defaulted participants. These beneficiaries have only one demographic in common: they are all financially unsophisticated. It is the belief of the TSP Trio that these naïve beneficiaries need protection so the risk of loss should be exceptionally low near the target date. The Duty of Care is like our responsibility to protect our young children; we’re accountable for protecting them from harm. Union plans embrace the Duty of Care.

Retirement researchers define a “Risk Zone” spanning the 5-10 years before and after retirement. Losses in this zone can spoil the remainder of life, even if markets subsequently recover. This risk is called “Sequence of Return Risk” because losses sustained early in retirement are much more harmful than losses later in life.  The TSP Trio believes that safety is paramount at the target retirement date. Professor Craig Israelsen opines “A target-date fund that fails to protect account value as the target date approaches has failed in its primary task.”

By contrast, the Big 3 group believes that because people have not saved enough and they’re living longer they need to earn more on their investments. The Big 3 believes TDFs should compensate for inadequate savings by taking risk to earn higher returns.   They aim to alleviate the ”Retirement Crisis” discussed next.

The retirement crisis

Baby boomers are the first generation to be responsible for their own risk decisions. Previous generations enjoyed defined benefit plans that provided lifetime annuities.

The Retirement Crisis is real. Most baby boomers have in fact not saved enough. 70% of baby boomers, which is 55 million people,  have saved less than $300,000. But an SEC report on “Perspectives on Retirement Readiness” says the solution is not to increase investment risk. Rather, the solution is modifying behavior by encouraging beneficiaries to save more. In fact, excessive risk could be the next 401(k) scandal because it can be argued that many TDFs are designed for profit rather than the benefit of participants: there’s a conflict of interest.

Inadequate savings do not warrant increased investment risk. Quite the contrary, lifetime savings need to be protected no matter how small because that’s all there is. Most of our 78 million baby boomers will spend much of this decade in the Risk Zone when investment losses can irreparably spoil the rest of life.  That’s why I wrote the book Baby Boomer Investing in the Perilous Decade of the 2020s.

Now is the time for Congress to act, and to avoid (learn from) the mistake of 2009. It’s admirable that this Congressional inquiry is proactive rather than reactive, as was the case in 2009.

Recommendation to Congress

The GAO will make its recommendation. I encourage it to recognize these two distinctly different standards but doubt it will mandate one over the other. It should instead require disclosure of risk at the target date and avoid the mistake made in 2009.

On June 18, 2009, the SEC and DOL held an all-day Hearing on Target Date Funds and Similar Investment Options to better understand the 30%+ losses of 2010 TDFs in 2008 with the intention of avoiding a recurrence in the future.  Subsequently, opinions were sought on incorporating a risk disclosure into fund names, since it was determined that fiduciaries need clear and prominent risk information. One such thought was to include the ending equity allocation in the fund name. For example, the “XYZ 2050 Fund Ending 60% in Equities.” The response was overwhelmingly negative, contending that there is more to risk than equity exposure, which is certainly true today since long-term bonds are very risky.   A technicality quashed the disclosure although the idea of risk disclosures makes sense.

Reviving this idea, Congress should require clear and simple disclosures of TDF risk at the target date, developing rules/standards for straightforward risk assignments to Negligible, Moderate and Severe risk of loss at the target date. Congress should appoint a committee to develop these rules and investment companies should be required to incorporate the resulting risk assignment into the fund name. For example, “The ABC 2050 Fund with Moderate Risk of Loss at the Target Date.” In my opinion, only Negligible Risk TDFs should be chosen as QDIAs, especially in union plans, with Moderate and Extreme versions offered as options to non-defaulted beneficiaries.

The TSP Trio is the standard for Negligible risk while the Big 3 is the standard for Moderate-to-Severe risk.

After the target date: Decumulation

Although most beneficiaries withdraw their savings when they retire, some retirees remain in the plan to take advantage of efficiencies, so decumulation is an important glidepath consideration. Many union plans encourage retirees to remain in the plan to protect themselves.

TSP  level risk at the target date cannot support a 30-year retirement, especially with interest rates near zero. Accordingly, research conducted by Professor Wade Pfau and Michael Kitces recommends re-risking beyond the target retirement date as shown in the following graph of a U-shaped glidepath that is both ‘To” and “Through” in TDF terminology. This innovation is not popular, yet, although it is employed by the SMART TDF Index and the OPEIU NRSP, the other 2 members of the TSP Trio.

Choosing a union standard

Defined contribution plans are replacing defined benefit (pension) plans because they enable an employer to better control the amount it contributes, and they permit beneficiaries to participate more actively in the process of building a personal retirement fund.  By carefully designing a defined contribution plan, trustees can provide affordable retirement benefits to members. The TSP TDF Standard pursues union principles of protecting savings to ensure a retirement with dignity.

The procedurally prudent choice is the Big 3 standard because the Big 3 manages most of the $3 trillion in TDF assets, but substantive prudence (doing what is right) requires a safer standard for these eight reasons.

1. There’s a “baton pass” at retirement from the 401(k) plan to either an annuity or an individual retirement account (IRA) since most beneficiaries withdraw their account at retirement. Investment losses drop this baton and reduce the standard of living throughout the rest of life.
2. There is a well-documented “Risk Zone” spanning the 5-10 years before and after retirement when investment losses can irreversibly spoil the rest of life.
3. DOL tips advise selecting TDFs to match workforce demographics. The only demographic that all defaulted beneficiaries have in common is financial illiteracy. These naive beneficiaries need protection.
4. We have a retirement crisis characterized by woefully inadequate savings. The Big 3 group aims to mitigate this crisis, but an SEC report warns against increasing risk because it could worsen the problem and recommends education instead that heightens awareness of the importance of saving: Save and Protect.
5. 78 million baby boomers will spend much of this decade in the Risk Zone.  They were not in the Risk Zone in 2008.
6. The stakes are extremely high. There is $3 trillion at stake today versus $200 billion in 2008.
7. There have been decades like the 1910s and 1970s when all asset classes had negative real returns. There is precedent, plus this current decade is not likely to be a repeat of the previous decade. Many believe we will see a major stock and bond market correction sometime in this decade.
8. Surveys of beneficiaries and advisors by PIMCO and Mass Mutual show a strong preference for low risk near the target date.

 Conclusion

“Safe” or “Aggressive” is a more meaningful choice than “To” or “Through” when selecting a TDF. And this choice is simplified by having two distinct standards, one of which is in line with union principles.

Ron Surz is President of Target Date Solutions and CEO of GlidePath Wealth Management. He is also the author of Baby Boomer Investing in the Perilous Decade of the 2020s. He can be reached at Ron@TargetDateSolutions.com.