What a Volatile 2020 Taught Portfolio Managers About 401(k) TDFs

Target-date funds were created with long-term investing in mind, designed to withstand the ups and downs of the market through a portfolio whose asset allocation mix becomes more conservative as retirement approaches.

But extreme volatility, such as what the stock market experienced in March 2020, can test the limits of even the most patient investor—or in our case, 401(k) plan participants with portfolios often heavily invested in TDFs.

Indeed, the extreme pandemic-related market volatility of 2020 presented TDF portfolio managers with plenty of learning opportunities. In 2021, those lessons learned are now turning into teaching moments, where they can help 401k advisors and plans sponsors understand how they can in turn help participants navigate the volatility without doing unnecessary long-term dam[1]age to their retirement accounts.

The risk, of course, is that extreme market volatility like the 12% plunge the S&P 500 took on March 16, 2020, as the seriousness of the COVID-19 pandemic became evident, can prompt rash panic selling that can cement losses as the market recovers, as it, of course, did before the end of last year.

To mitigate this risk, there seems to be a concerted effort among purveyors of TDFs to design and manage them to instill confidence in participants, or at least, trumpet the inherent qualities that make them well-suited to younger investors as well as more risk-averse participants.

“The COVID-19 pandemic taught us that target-date funds are perfectly suited for individuals who feel apprehension about market volatility,” said Randy Welch, Managing Director and Portfolio Manager at Principal Global Asset Allocation.

“During the pandemic, we saw that people who stayed in their target-date funds saw a very positive result by the end of December, especially compared to self-directed investors who panicked and jumped out of the market,” Welch said.

There were plenty of people who didn’t stay put. During the first quarter of 2020 alone, net outflows from TDFs in retirement or within five years from retirement totaled $11.9 billion, almost 15 times greater than the 2018 quarterly average, and in sharp contrast to the net inflows seen in 2019, according to a Feb. 24 investment insight brief from PIMCO.

“The performance of target-date strategies over the last year, since the volatility in March 2020 initially spooked investors, confirmed for us that people who stayed in target-date funds and, in turn, allowed us to navigate the waters for them and re-risk their portfolios appropriately when the market took a downturn, were rewarded by the end of the year,” Welch added.

The target-date fund was established because it offers an appropriate asset mix and an appropriate risk-return profile based on the years until retirement, by using diverse asset classes and diversifying asset class exposures, Welch noted. “The confidence for investors is that when there are shocks to the environment, we will manage the portfolios and address the impact of market volatility. We handle the rebalancing and reallocations, which should keep people from making rash decisions and selling out of their investments.”

A perfect example, Welch added, is the extreme volatility of the S&P 500, which ended up over 18% at the end of 2020, but was down more than 20% over 24 days in February. “If investors jumped out during this downturn, they locked in a loss and missed out on those eventual upswings,” Welch said. “Target dates create a vehicle that encourages participants to stay the course during periods of volatility, so they don’t miss out on potential gains.”

Personalized service

Another lesson learned from the pandemic and the past year would be an increased participant appetite for personalized advice.

“Most participants don’t know how much to be saving. As a result, advisors increasingly want to offer their clients personalized advice through managed accounts that can help participants navigate through volatility, tell them how they need to save to retire comfortably, and do it in a cost-effective, transparent way,” said Joshua Forstater, SVP of Strategic Partnerships at Vestwell.

Principal’s Welch said he also feels a sense now that target dates need to be more customized for investors. “TDFs are extremely valuable as people reach ages 50-55, and there could be an opportunity for more customization for investors based on how they’ve saved or if there are other asset strategies they want to employ,” Welch said. “We see technology providing a massive opportunity to interact more effectively with investors, providing them with information seamlessly and offering us the ability to customize solutions to address their specific financial situation, outside of a traditional glide path.”

He added that target dates are still very much a valuable product for the beginning investor, ages 25-50.

“While managed accounts could be better if there’s greater assets and information from the actual investor, many people just starting out in the workforce don’t have those mechanics. Barring any additional information, an efficient glide path will help effectively manage a person’s wealth during those first working years,” Welch said.

Trend toward blend

With active management entailing higher fees (bringing its own range of issues), it’s important to consider the value proposition between active and passive.

The aforementioned PIMCO brief stated that a blend of active bonds and passive equities gives the best of both worlds, and this trend continues to gain momentum. A 2020 “Featured Solutions” brief from PIMCO noted that TDFs that blend active and passive funds have grown nearly five-fold since 2013, as the number of offerings increased, and they expect the trend to continue because blend TDFs typically carry lower fees than fully active offerings, without fully sacrificing alpha potential.

Forstater agrees, with a caveat.

“Yes, we continue to see a trend towards fund lineups that have passive equity funds and active bond funds,” Forstater said. “However, many advisors feel there’s a place for active management, especially in satellite areas like High Yield or International Small Cap.”

At Principal, the blend of actively managed and passively managed investment op[1]tions within target-date funds is called the Hybrid CIT model, which Welch notes was launched in 2009. It features a multi-managed approach that combines the competitive results of active solutions with a passive component to help control costs, leading to greater portfolio efficiency.

“We expect hybrid strategies that produce alpha generation and enhanced returns through active management will continue to be attractive,” Welch said. “During periods of extreme volatility, like what we experienced in 2020, we see that active management allows for more efficient navigation. The market selloff and recovery were very quick, highlighting these efficiencies further over the past year.”

Adding in annuities

Thanks to the SECURE Act, target-date funds are able to provide more flexibility and access to annuities within defined contribution retirement plans, which in turn are increasingly starting to provide lifetime income options.

“Yes, innovation is ramping up, and we’re looking forward to hearing more from clients about what they really want. We see the combination of fintech trends, managed accounts, and guaranteed income coming together to produce very interesting solutions for clients,” Vestwell’s Forstater said.

While TDF strategies use to be about getting 401k plan participants to retirement, recent approaches, which some (like Morningstar’s David Blanchett) are calling TDF 2.0, are focusing on getting participants through retirement by embedding annuities in the later stages of the TDF strategy.

Principal’s Welch said it has been an age-old conundrum to figure out how to take 401k dollars and convert them into guaranteed income streams as we approach retirement. “At this point in time, we have yet to see much movement in terms of embedding annuities into target dates, given issues of complexity surrounding portability,” Welch said. “The SECURE Act has certainly brought more attention to guaranteed income streams as a whole, and we believe it will continue to foster an environment of innovation in this space.”

Two recent examples leap to mind. First, in February, Nationwide and Annexus Retirement Solutions partnered to bring “Lifetime Income Builder” to market, a new in-plan guaranteed income solution that provides plan sponsors with an efficient structure designed to be QDIA-compliant and that offers a combination of liquidity, portability, and ease of use.

It embeds a fixed indexed annuity with a guaranteed lifetime withdrawal benefit directly into a collective investment trust consisting of a series of target-date funds. This increases income potential while maintaining a familiar investment experience for the participant due to the target-date fund structure.

“It’s an exciting time—a true paradigm shift—for the workplace retirement plan industry and the plan participants we serve,” said Eric Stevenson, President of Nationwide Retirement Plans. “This innovative new investment option allows us to better serve existing plan sponsors and consultants while also reaching new clients by providing their participants with the protection they seek, and the guaranteed income they need, to help them achieve a more secure retirement.”

The second example? The recent launch of Income America, a new in-plan target-date series featuring guaranteed income for life designed to help 401k plan participants transition from the accumulation phase of retirement investing to the decumulation stage.

Led by former Fi360 president Matthew Wolniewicz, the new company is backed by American Century Investments, Lincoln Financial Group, Nationwide, Prime Capital Investment Advisors, SS&C technologies, Wilmington Trust, N.A., and Wilshire.

Called “Income America5ForLife,” this new solution, which is designed to be used as a plan’s Qualified Default Investment Alternative (QDIA), strives to address one of the most pressing issues for those at or near retirement: the need for guaranteed monthly retirement income.

“Working together with our retirement industry partners, we developed the ‘Income America’ consortium to offer a defined contribution solution that helps plan participants concerned about outliving the money they’ve set aside for retirement,” said American Century Investments President and Chief Executive Officer Jonathan Thomas. “Our recent 2020 Retirement Plan Participant study indicates that more than 80% of participants would keep their assets in their retirement plan if they had an income option. We believe Income America provides an innovative approach to helping more people achieve a successful and comfortable retirement.”

Available in April, the Income America 5ForLife product is designed to be SECURE Act-compliant, structured as a multi-managed and multi-insured target-date fund that offers 3(38) and 3(21) fiduciary protections. The product also guarantees 5% per year, beginning at age 65, safeguarding against market uncertainty during retirement.

American workers see great value in products that provide guaranteed income in retirement, according to recent Lincoln Financial research.

More than seven in 10 surveyed said they would use a guaranteed income product if offered in their employer-sponsored retirement plan. The same number said these solutions would make it easier to budget their money in retirement, and they would feel more confident in preparing for retirement. Plan participants are also focused on protecting their savings from market volatility—as a result of the financial impacts of COVID-19, half of the retirement savers are more concerned about future market volatility than they were before the pandemic.

The past year has brought plenty of lessons for TDF portfolio managers, and 401(k) plan participants figure to be the beneficiaries of what was learned.