Why Target Date Funds Keep Looking Better

The popularity of target date funds continues to grow. What’s new? How are TDFs being refined, tweaked and updated to outperform? We run through the smart new products, as well as the tried and true.

401k, target date funds, retirementLove em' or not, they're moving in the right direction.

It was only a matter of time before we’d see headlines like this: “3 Reasons Target Date Funds Aren’t Right for Anyone!”

Got that? Anyone (!), ever, suitability be damned.

The article’s author is quick to acknowledge its incendiary nature before plowing ahead and trashing the investment scheme altogether, and truth be told, somewhat convincingly. It could be counted as a badge of honor and sign of success that target date funds have hit that coveted point in a particular product’s lifespan—the hater stage.

Given the product’s stratospheric growth and widespread praise, not only for its 401k fit but also the role it plays in ensuring good (or at least better) participant behavior during market shocks, a contrarian backlash was all but assured.

No product is perfect, and it can be argued that the true measure of its worth is if it’s better than previous variants at steering participants toward successful outcomes, which in certain respects target date funds undoubtedly do.

They’re certainly experiencing stronger performance than similar products at this stage of their development (early attempts at long-short equity funds come to mind).

For this reason—in this age of fiduciary responsibility—plan advisors, sponsors and participants are dumping buckets of money into various TDF offerings.

Assets topped $880 billion in 2016, up from $763 billion the previous year, according to research behemoth Morningstar. It should be noted this growth sprung from investors putting more money in the funds as well as positive returns 401k participants were able to realize, but still, it’s an impressive figure.

They earn solid praise for how well they kept investors sane and on track through the 2008 economic crisis.

And even perma-grumps like Jeremy Grantham are finding value, with GMO recently noting that “adding a dynamic component to the target date fund glide path, combined with an earnest effort to boost deferral rates appears to have the potential to deliver the biggest bang for the buck,” when looking to enhance the product.

So where are they now, and what does the future hold for this darling of the DC space?

Target-date funds have been on a remarkable growth trajectory, with assets climbing from roughly $125 billion 10 years ago to nearly $900 billion recently,” Morningstar’s Jeff Holt, associate director of multi-asset strategies research, recently wrote in his “Target-Date Fund Landscape Report.”

What’s more, the funds have become the main source of new asset flows to many firms, “accentuating their importance.”

Increasing demand for low-cost options in the face of litigatory and regulatory pressures has some (including Cerulli) worried about its effect on innovation, and whether development of new solutions could stop at the very moment the retiree demographic needs them most.

Holt and Co. isn’t buying it, adding that contrary to nattering naybobs and their frets over fee pressure, low-cost concerns have actually “affected how target-date providers approach their funds and has caused many to branch out with additional offerings.” [Emphasis ours]

The $880 billion by the end of 2016 figure previously mentioned was partially due to an estimated $59 billion in net inflows for the year. And in yet another sign that the younger passive investment sibling continues to kick the (pants off ) its older active big brother, approximately two of every three dollars directed to target-date mutual funds in 2016 went to series that invest predominantly in index funds.

Quick aside: Target date boosters like Holt note there’s really no such thing as a completely passive target date funds, as managers (and preferably advisors to limit their legal exposure) should actively manage the underlying passive investments within the glide path to ensure expected outcomes are achieved.

The Big 3—Vanguard, Fidelity, and T. Rowe Price—continue to dominate in the space, holding more than 70 percent of target-date mutual fund assets. However, Vanguard (as usual) was the only one of these three to increase its market share in 2016; the firm had $37 billion in net inflows to its target-date funds in 2016.

For an indication of how far TDFs have come, consider that at the end of 2016, 12 firms offered more than one target-date series in an attempt to cater to different investor preferences. By contrast, Morningstar reports, no firm offered more than one series 10 years ago.

And the average asset-weighted expense ratio for target-date funds fell to 0.71 percent by the end of 2016, a notable decrease from 0.99 percent in 2011.

Perhaps most significant, target-date funds “show a positive 1.4 percentage point investor return gap over the 10-year period through 2016, showing that investors have reaped benefits from making steady contributions to the funds.”

“The reality is that target-date funds must be competitively priced to thrive,” Holt emphasized, before adding somewhat obviously (but importantly), “Everything equal, lower fees indeed provide a discernible advantage, but we’ve found that even similarly priced target-date funds can differ in potentially meaningful ways. In fact, target-date funds generally look the most different from one another at the retirement date, when their results matter the most.”

As for that aforementioned innovation, examples include BlackRock’s inclusion of smart beta strategies in its BlackRock LifePath Active series, renamed BlackRock LifePath Smart Beta last November. The $5 trillion mega-manager claims it’s “among the first TDFs of its kind, with its exposures converted to 80 to 90 percent iShares smart beta exchange traded funds (ETFs).”

In a sign of the appeal of impact investing—especially with millennial 401k participants—Natixis Global Asset Management launched a series of target date funds in February that follow a “sustainable investing approach.”

Offering 10 funds with dates ranging every five years from 2015 to 2060, it selects securities based on ESG criteria including fair labor, anti-corruption, human rights, fair business practices and the “mitigation of environmental impact,” according to Matthew Garzone, AIF, senior vice president of the Retirement Strategies Group with Natixis.

And more recently, Nuveen added direct real estate investments as part of the allocation in its target date fund series in late April, a first-of-its kind in the industry (and for good reason, it’s complicated).

The offering, available in its TIAACREF Lifecycle Funds, has three objectives, according to John Cunniff, managing director at TIAA Investments and portfolio manager of the TIAA-CREF Lifecycle Fund series—greater diversification, risk reduction and better positioning for investors to meet long term investment goals.

One final bit of information for those still skeptical; 401k trading activity in 2016 was punctuated by a few spikes due to Brexit and the November election followed by long lulls of low activity, thanks largely to target date funds, Aon Hewitt reports.

“For 2016, a net total of 2.13 percent of balances traded—slightly higher than the trailing five year average (2.02 percent), but below the trailing ten year average (2.59 percent).”

It lends additional credence to the positive behavioral impacts the product is making on participants, and thus on the industry as a whole.

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