Retirement Plan Progress with One Major Step Backward

The typical ERISA qualified plan has come a long way over the past 25 years; fees have come down, while QDIA, automatic enrollment, and fiduciary advice all have contributed to a healthy evolution of participant directed plans. Yet even as we acknowledge this, there is one underlying item that has taken a significant step backward.

In the early 1990’s, what did we observe, from an investment standpoint? At that time, much of the focus was on educating employees to diversify away from their stable value option (originally known as Guaranteed Investment Contracts, or GICs) and embrace the concept of asset allocation via a menu of mutual funds.

This created a phenomenal business model for the recordkeeping fund companies, as most all the options were propriety funds. If your plan was with Fidelity, you had Fidelity mutual funds to choose from, T. Rowe Price had T. Rowe Price Funds, Vanguard had Vanguard funds, and so on.

The rise of independent recordkeepers through the years coincided with open architecture; no longer were plan participants limited to just one fund family. This revolutionized investment menus as retirement plan sponsors and their consultants worked tirelessly to create best-in-class lineups from multiple fund companies.

It was good until it wasn’t—the market downturns of 2008 hit, and millions of people realized maybe they were not in the best position to manage their retirement money. Hence, the rise of the retail target date fund, which brings us full circle to today.

The sad reality that comes with more and more retirement plan participants placing their retirement money into target date funds is that we have taken a step backward, to the proprietary fund family model of the early 1990’s.

Today, if you’re using the Vanguard target date funds, you’re investing 100 percent into their underlying products, an arrangement also true with Fidelity, T. Rowe Price, American Funds and nearly all the other retail target date funds in the marketplace. Why is this a bad thing? To help illustrate, let’s examine the table below.

The table shows a handful of target date families who, as a group, currently hold just over 85 percent of the assets within the target date industry. We first classified their stable of products into three broad asset classes–equities, fixed-income and a “catch-all”, alternatives. We then calculated the average star rating by category, as defined by Morningstar.

Highlighted in yellow is the highest average star rating for this group within each category, assuming it has at least four stars. And if a fund family doesn’t have a product within a particular category, we noted it with the word ‘none.’

The first column is U.S. Equity, and as you can see, T. Rowe Price and Vanguard have the highest average star rating of this group, at four stars. If you rely on the rating methodology used by Morningstar, these two firms may be the best choice for U.S. equity. For emerging market equity, American Funds seems to have the secret sauce; for global real estate, John Hancock excels, and so on.

But what about U.S. fixed Income? This critical asset class shows that none of these target date providers are currently excelling here. There is similar performance diversity in U.S. real estate, commodities and others. Worse yet, many asset classes used by institutional investors are not available with these complexes.

Even when they are (i.e. Vanguard’s Market Neutral strategy), they do not often use them in their target date series. As another example, consider American Funds: most of what we are labeling as alternatives are noticeably absent from their list of available products. Review Fidelity or JP Morgan, and only in one category do these firms have an average rating of four or more stars, while American Century has none.

Of course, the target date families would argue that they only incorporate their best funds within a given category, so this table is misleading. While technically that may be correct, it misses the point; why use a target date fund that only holds its own proprietary products? No one firm can offer best-in-class solutions for all the potential asset classes, factors, styles, etc.

The investment universe is simply too vast and complex for even the largest fund companies to excel in all places, let alone to do consistently over time. And as we’ve stated, for these retail-oriented target date fund series, many alternative asset classes that have been incorporated into institutional portfolios are notably absent.

For decades, large institutional investors have successfully created truly diversified, multi-manager portfolios for their defined benefit plans, foundations, and endowments. That approach has mostly failed to take hold in the retail-oriented defined contribution plan environment.

Fiduciaries seeking the best interests of plan participants should no longer accept that proprietary fund model with it inherently limited diversification benefits. Plan sponsors and their consultants must demand target date and target risk funds that take full advantage of all the asset classes available, with best-in-class managers. The American workforce deserves as much.

David Halseth is chief investment officer with Denver-based Strategies Capital Management.