Are Target Date Funds Missing the Mark?

Without a doubt, target date trends are headed (sharply) north. Target date mutual fund assets grew almost 5 percent in the second quarter, topping $1 trillion at the end of June, according to the Investment Company Institute (ICI).

The bulk of the assets were held in retirement accounts, 87 percent of which were held through defined contribution plans (67 percent) and IRAs (20 percent).

Generally praised for keeping participants invested through the worst of 2008, their role in influencing positive outcomes is something that’s resonating, especially now and with a Nobel win for Richard Thaler for behavioral insight into 401(k) saving.

But not all industry players are so enamored with the popular product, and they might have a point, noting that an evaluation of where we are in the TDF lifecycle is in order, as well as an examination of whether or not they’re actually doing what they claim.

Count Dave Haviland, for one, as not all that impressed.

“Target date funds are not doing what they were designed to do, which is to keep people from losing money,” Haviland, managing partner with Boston-based Beaumont Capital Management, bluntly states. “They do not take market shocks into account.”

Despite claims from Morningstar’s John Rekenthaler, among others, as to the efficacy of the product through the last major downturn, Haviland notes that assets invested in top TDF providers lost between 21 percent and 27 percent in their 2010 portfolios.

Granted, the Dow Jones lost over 50 percent of its value during the same period, so relative performance wasn’t all that bad, but we get his point.

What’s missing, he claims, is a component to deal with that most pressing and annoying of all risks, sequence-of-returns.

Put plainly, sequence-of-return risk is the danger of retiring into a down market, when lower returns are received early on and at a time when money is withdrawn to fund daily living expenses, among other things.

The investment portfolio is diminished at an exponential rate, as assets are no longer available to capitalize on the market recovery to come. It’s too often a devastating situation from which many retirees never recover, diminishing their affordable quality of life in retirement.

So yeah, it’s a problem, made more so by the fact that what’s rapidly becoming the “go to” retirement savings product hasn’t taken it into account, at least according to Haviland.

“If your client lost a quarter of their savings within two years of retirement, could they still afford to retire? For most, probably not.”

Part of the issue, he adds, is that the industry is not actually listening to what participants want—instead relying on outdated stereotypes and misconceptions of what we think they want.

“The latest example is that the youngest investors [supposedly] want, and can handle, the most risk,” Beaumont argues in a recent report. “This long-held belief is based only on the long recovery times your investors have,” thereby dampening the sequence-of-return risk.

However, aggressive growth doesn’t square with what millennial participants say they want when asked, at least according to Cerulli Associates.

The research and consulting firm reports that only 7 percent of millennials want aggressive growth early on in their careers.

More importantly, and specific to the sequence-of-return discussion, is that two-thirds of those surveyed want to be more conservative in their allocations, and fully 77 percent said, “they would prefer to be protected from large losses even if it means underperformance.”

Thankfully, the industry is responding, specifically with more “through” (as opposed to “to”) glide paths seen recently from major mutual fund families, and a general awareness overall of the actuarial Achilles heel.

For example, Putnam Investments addressed sequence-of-return risk in a September release, describing how its Retirement Advantage Funds address the issue.

“We believe it is important to consider this risk in the glide path,” according to the company. “While many glide paths continue to emphasize equity exposure leading up to and through retirement in an effort to reduce possible shortfalls, we believe that they are exposing participants to unnecessary and potentially devastating sequence-of-returns risk.”

Columbia Threadneedle is out with its Columbia Adaptive Retirement Series, which employs a rules-based “market state classification,” designed to identify exceptions to normal market conditions and offers the ability to “reallocate risk systematically and meaningfully as market conditions change.”

“Aligning portfolio allocations with the current market environment provides investors with a potentially superior risk-return profile,” it notes.

And Beaumont, of course, has its Target Date Collective Investment Funds (the collective investment trust format being an added low-cost bonus), which combine strategic and tactical management, which helps “make bears more bearable” as the firm colorfully notes.

“The tactical allocation component can seek to preserve stock and bond allocations if either or both experience a down market,” Haviland adds.

NAVs and Nepotism

In addition to sequence-of-return risk is another area of potential target date concern—the use of proprietary products in a fund family’s underlying investment offerings.

The Department of Labor addressed the issue some time ago, offering the following “guidance” in its closely examined and widely-cited memorandum released in 2013, titled Target Date Retirement Funds –

Tips for ERISA Plan Fiduciaries:

“Some TDF vendors may offer a pre-packaged product which uses only the vendor’s proprietary funds as the TDF component investments. Alternatively, a ‘custom’ TDF may offer advantages to your plan participants by giving you the ability to incorporate the plan’s existing core funds in the TDF. Nonproprietary TDFs could also offer advantages by including component funds that are managed by fund managers other than the TDF provider itself, thus diversifying participants’ exposure to one investment provider. There are some costs and administrative tasks involved in creating a custom or nonproprietary TDF, and they may not be right for every plan, but you should ask your investment provider whether it offers them.”

While proprietary fund use is a frequent source of target date fund criticism and a potential fiduciary nightmare for plan sponsors and advisors, that trend appears to be headed in the right direction as well (although there still seems to be a long way to go).

A recent study from retirement plan research firm BrightScope and Alliance-Bernstein reveals a “dramatically shifting target-date landscape where record-keepers who offer their own target-date funds–known as ‘proprietary’ funds–are losing share of assets on their own platforms as plan sponsors are increasingly choosing funds from other providers.”

Since 2009, it finds, plan sponsors have cut back on using record-keepers’ proprietary TDFs, with the share of record-keepers’ proprietary assets declining from 59 percent to 43 percent.

Conversely, the use of non-proprietary TDFs offered by outside asset managers increased by 16 percent.

“The trend depicts a very different landscape from that in 2006, after the Pension Protection Act was passed and led to a boon for record-keepers who benefited from offering prepackaged, proprietary TDFs with prices bundled with the plans’ administrative costs,” according to BrightScope. “Today, however, large plans are leading the migration to TDFs other than their provider’s offering.”

Ultimately, while significant issues still exist in target date fund design and execution, their popularity (and effectiveness) in 401(k)s continues to rise. While concerns like those expressed above are worthy of discussion, it appears they’re criticisms the industry is taking steps to address, resulting in better products for participants, and better protection for retirement plan professionals.