The retirement plan industry continuously evolves through product innovations and advances in technology. To provide participants with the best options to achieve their long-term goals, the industry and its employer clients have adopted new programs and adapted to changes in both regulation and industry ingenuity.
Participants currently have a variety of different investment options depending on their plan, including plan menu selections, asset allocation funds, target date funds, and managed account solutions.
Which solution is the best fit?
Plan Menu Selection by participants is one method to build a portfolio. They can construct their own portfolio from the plan’s investment offerings, but this carries disadvantages if they aren’t financial professionals with the expertise to construct a risk-appropriate allocation. This can also lead to poor attempts at market timing and return chasing.
Asset Allocation (e.g.: Target Risk) Funds are designed to maintain an equity/fixed income asset allocation within a defined range over time—for example a 60% stock and 40% bond allocation. However, the asset allocation does not change with an investor’s risk profile over time.
Target Date Funds are designed to provide a diversified asset allocation that gradually becomes more conservative as the participant reaches retirement and beyond—known as a glidepath. They aren’t tailored in any way to the individual participant. They are a one-size-fits-all solution.
What does visualization reveal?
With proper technological and analytic tools, we can create new concepts in visualization. With this technology, our team at LeafHouse decided to compare the two previously mentioned investment vehicles, Asset Allocation Funds versus Target Date Funds.
When plotting five-year returns, alpha, and beta of asset allocation funds versus target date funds much is revealed. In the following illustrations, we can visualize how Target Dates and Asset Allocations compare to one another. To provide the most accurate comparison and account for to- and through- glidepaths, each allocation fund is matched with its best fit target date fund.
Figure 1 compares 2020 target date funds versus 30-50% asset allocation funds. Notice how the return distributions for the asset allocation suite range from -0.1% to 18.4% where the target date returns range from 5.3% to 11.1%. Whether you are in an active, passive, or blend target date, regardless of cost, the fund returns from the best to worst are different by 5.8%. The asset allocation suite has a much larger distribution of returns since they are not required to stay within certain glidepath limitations and asset allocation restrictions.
In Figure 2 below, we compare 2035 target date funds versus 50-70% asset allocation funds. Again, we see that the asset allocation managers have less restrictions due to the lack of glidepath constraints.
With a 50-70% portfolio, the manager can make broad equity and fixed income allocation decisions that affect the return outcomes for the fund. The return distributions range for the asset allocation funds come in at 26.7% compared to the target date funds at 6.3%. At the end of 2021, the average equity exposure for a fund in the 50-70% allocation category was 60% while target date 2035 vintages had an average of 67%. The asset allocation category returned 13.93% and outperformed the 2035 category by 16bps. Higher returns with less equity, relative to a target date, are attainable but require additional due diligence to find.
Lastly, Figure 3 compares 2060+ target date funds versus 85%+ asset allocation funds. The 2060+ funds show more variances than the prior charts but is primarily due to the category containing both 2060 and 2065 vintages.
The 2065 vintages will have the highest equity allocations on the glidepath. The return distributions vary more widely with these vintages because each investment manager has different assumptions on what the optimum starting equity allocation should be for a participant. The glidepath will continuously maintain and rebalance the specific allocations like equity, such as US and Non-US.
The allocation manager is not beholden to such strict allocation mandates and can maneuver through equity and fixed income allocations based on their economic and market views. We can see this by analyzing the higher returns (24.6% compared to 15.6%) and return variances (21% compared to 6.3%) with the 85+ allocation suites.
In summary, target date funds show very little variance relative to asset allocation funds, with more clustered 5-year alpha and beta numbers, and 5-year returns around the same level.
Asset allocation funds provide much more variability regarding outcome, with more upside potential as can be seen by the 5-year returns relative to target date returns. Clearly, there is not much difference between managers in the target date space when juxtaposed with asset allocation funds of a similar risk level. The opposite is true for the asset allocation funds; there is clearly a greater range of both return and risk.
Target dates serve a broad purpose because they automate asset allocation changes based on the glidepath. However, our new knowledge gained from using this visualization technique reveals there is little differentiation from an outcome perspective. Allocation funds appear to give investors a higher chance of outperforming, but many will never make adjustments to the asset allocation—like what would occur if they were on a glidepath. Unlike target dates, asset allocation funds require proactive participation from the investor to move from one target risk fund to another as needed due to age and circumstance.
Given the pros and cons with asset allocation funds and target date funds, what should a participant choose? Neither solution is perfect; thus, it’s really a combination of the two that is the best option: a managed account.
What is the best of both worlds?
Personalized Managed Accounts offer unique asset allocations for the specific individual at the appropriate level of risk over time. The asset allocation is adjusted over time like a target date fund glidepath. With continued fee compression, the ideal solution to provide plan participants is a low cost, managed account program that optimizes and personalizes the investment experience from start to finish.
As fees continue to decline, technology improves, and the level of personalization continues to increase, we believe the next chapter of retirement plans will favor Personalized Managed Accounts. There truly is no one size that fits all.
SEE ALSO:
• The Great Debate: Target Date Funds vs. Managed Accounts
• The Advisor Opportunity in Managed Accounts
• Target Date Funds are Not Protecting Those Near Retirement
Michael Garberich is a senior investment officer at LeafHouse Financial.
