(From 401(k) Specialist, Issue 3, 2016)
“Target date funds are the most expensive vanilla ice cream in the world,” one 401(k) advisor recently noted with a laugh.
Maybe so, but Cerulli Associates estimates that as of year-end 2015, target-date assets held in 401(k) plans surpassed $900 billion. While the amount of assets in any one product or asset class hardly equates to their effectiveness in delivering solid risk-adjusted returns, it’s clear target date fund manufacturers and managers are on to something.
As with anything that experiences explosive growth in a relatively short period of time, they’re not without controversy. The American Institute for Economic Research lists their lack of personalization and high fees as top complaints from detractors.
“So what,” say supporters, and counter with essentially the same argument to all—target date funds are better than having 401(k) participants allocate for themselves. There’s merit in the argument.
“[I]t’s clear that investors do better with balanced or target-date funds, where the asset-allocation decision is taken out of their hands, than they do allocating on their own,” industry personality Don Phillips, managing director with Morningstar, writes in recent commentary.
REDUCING THE ‘EXTREMES’
Indeed, a number of 401(k) advisors readying late-career participants for retirement relate the following frustrating tale. When asked about retirement (or decumulation) objectives in anticipation of a switch from the accumulation stage, most clients insist on conservative asset-protection strategies. When examining their portfolio allocation however, the advisor often sees an 85 percent allocation (at least) to equities— this at age 60 or 65, which reinforces the point that typical savers either will not or cannot effectively allocate assets to synch with their stated goals. It’s for this reason, say supporters, that target date funds are better than nothing.
“It’s been 10 years since the passage of the Pension Protection Act of 2006, and in that time we’ve seen target date funds gain steam and result in positive outcomes,” says Meghan Murphy, a director on Fidelity’s Workplace Investing Thought Leadership Team. “In 2006, we saw a lot more of what we call ‘extreme’ allocations; those that have either 100 percent in equities or zero percent in equities. Today, we see about one in eight savers with extreme allocations.”
Matthew Brancato agrees, arguing that target date funds are a great innovation in the retirement industry, tangibly “moving the dial” to help participants plan for the future. He too points to the reduction in extreme portfolio allocations as proof of their effectiveness.
“Look at allocations and the reduction in the number of those that are extreme versus those now considered ‘balanced,’” says Brancato, a department head in Vanguard Institutional Investor Group responsible for DC Advisory Services, as well as a former Target Retirement Fund product manager with the Pennsylvania-based fund family behemoth. “It’s also illustrative to observe how participants in target date funds react in tough markets, where they’re less likely to work against themselves. Target date funds were not designed to be an optimal portfolio for every investor; they were designed to be an optimal starting point.”
REWARDING GOOD BEHAVIOR
It’s his point about participant behavior in tough markets that are making target date funds more attractive to a wider number of 401(k) advisors and plan sponsors, something to which analysts at Morningstar repeatedly emphasize.
“We see target date fund investors in particular, behaving very well,” Laura Pavlenko Lutton, director of manager research practice for the Chicago-based research firm, said during a recent industry conference session. “Especially in 2008, they didn’t panic and reached the rebound of 2009.”
Russ Kinnel, Morningstar’s “Fund Spy,” agreed, noting that “TDF investors received far and away the best returns” over the past few years, and credited the funds “boring structure” for the absence of fear and greed on the part of investors that generally leads to self-destructive behavior.
“We heard around 1999 and 2000 how supposedly 401(k)s were deficient and investors would be the first to crack, and that the savings vehicle wasn’t structured properly and it would hold up,” John Rekenthaler, Morningstar’s vice president of research, added. “But the opposite was true. TDFs were strongly positive through 2008 and 401(k) investors stayed put more so that other types of investors. This is something that analysts and researchers are now studying.”
PROPER USE
With recent volatility—for instance, during the latter part of June and Brexit, as well as a day in August when all three major U.S. stock indexes set records on the same day for the first time since Dec. 31, 1999—good behavior on the part of target date participants is undoubtedly a good sign, but only if they use the product correctly.
“To take a step back, 401(k) investors move investments less often than regular retail investors,” says Joe Martel, portfolio specialist in the Asset Allocation Group for T. Rowe Price. “And 401(k) investors in target date funds move money even less than that. We saw this during the 2008 economic crisis, the volatility caused by the 2011 U.S. debt downgrade, and the volatility during the back half of 2015; it was all consistent. However, in our view participants should select one target date fund in which to invest.”
It seems counterintuitive, given all the talk about proper asset allocation and diversification, but research from Financial Engines back him up. The RIA founded by Nobel laureate Bill Sharpe of Sharpe Ratio fame recently found that only one quarter (26 percent) are using the target date funds as intended. Two-out-of-three (64 percent) target-date fund investors hold only a portion of their investments (less than 90 percent) in the funds, “potentially harming their investment returns compared to those fully invested in target-date funds.”
Despite moving away from being fully invested in their target-date fund, 81 percent of participants said that they understood that target-date funds are diversified by design and that they knew how they worked.
“While the ‘set it and forget it’ promise of target-date funds is appealing to some investors, most participants don’t forget it—they are actively investing away from the target-date fund in their portfolios,” explained Christopher Jones, chief investment officer of Financial Engines, upon the research’s release.
The reason is what one would expect; while target-date funds are designed for participants to invest all of their retirement assets in a single, age-appropriate fund, 62 percent of partial target-date fund users cited a desire for greater diversification and a fear of “putting all of their eggs in one basket” as the primary reasons for moving money away from target-date funds.
“One target date fund should give them a wide allocation to diversify their assets,” Martel adds. “The problem with using more than one fund, as well as other investment vehicles, is that the participant might then be over-allocated for over-concentrated in a particular sector. Whether they have a high risk tolerance or a low risk tolerance, it’s better to be in one glide path then not.”
NEAR TERM TRENDS
The same key trends are singled out time and again by target date fund advisors and experts. The first is a move away from active management to more indexed based products, something Martel refers to as “dramatic” and especially true in QDIAs, mainly for the transparency aspect.
Over the next five years, the shift to open architecture and away from active managers to blended or passive managers will continue,” agrees Susan Viston, client portfolio manager and head of investment services for multi-asset strategies and solutions (MASS) at Voya Investment Management.
Second, Martel notes, is that fees continue to fall.
“Fully 95 percent of plan sponsors that designate a QDIA are using a TDF. They are passing along economies of scale to sponsors and participants, so fees will continue to come down with fiduciary scrutiny; that is happening.”
Lastly, says Viston, there will be a continued focus on driving better outcomes, “either through some sort of lifetime income solution that might involve a higher equity allocation, or where some income replacement will be traded for more certainty around retirement, which might involve a lower equity allocation.”