The emergence of target date funds (TDFs) has proven vitally important for the retirement industry. Over the last 10 years, their significance has been magnified by key provisions of the Pension Protection Act of 2006 (PPA). However, like most innovative solutions, their benefits are somewhat offset by drawbacks that deserve inspection. Here, we will take a look at TDFs in the retirement industry, then probe deeper, comparing and contrasting them to another investment option in the space – Managed Accounts.
TDFs have experienced explosive growth driven by the PPA’s provisions for selection of a Qualified Default Investment Alternative (QDIA). In essence, instead of having plan participants actively select investment options, they are defaulted into a QDIA and must actively choose not to be by opting out. Studies show 80% of defined contribution plans now have a QDIA. [1]
While managed accounts and balanced funds may also serve as QDIA options, target date funds have been by far the most popular. In less than 9 years, target date fund assets under management (AUM) grew ten-fold to over $700 billion by the end of 2014.[2] Studies predict that by 2018, 63% of new contributions will go to TDFs.[3]
Are Target Dates the Right Answer?
At the core of target date fund design is the commonly held belief that aging participants won’t make their own decisions, and that they therefore need to be placed onto a ‘glide path’ that moves them along a path that emphasizes growth at earlier ages and protection as they near retirement. The benefit here is the allocation change happens automatically, and the investor does not have to adjust it on his/her own. Ultimately this hands-off approach has led target date funds to be coined a “Set it and forget it” option, with very little to no action needed from the participant. This logic has been espoused by the financial services industry at least since the advent of TDFs, and was affirmed by the government with the PPA. However, let’s look at whether widespread use makes TDFs the best available solution.
The short answer: not necessarily. In fact, several problems have emerged. While not necessarily a TDF issue in itself, studies show target date participants are less likely to increase their contribution rates over time.[4] That is an obvious problem since a study recently showed over 80% of retirement plan participants lack confidence with their preparation for retirement.[5] Additionally, studies show 62% of participants use TDFs incorrectly (which could include not using a TDF that corresponds with their age or even using multiple TDFs).[6]
Another issue is that TDFs generally follow a single static asset allocation glide path. While the annual asset allocation change itself may be beneficial, it fails to account for the unique financial and psychological characteristics of the individual plan participant such as risk tolerance, personal retirement goals, current savings rate, outside assets, spousal plans, and critical needs along the way to retirement like educating children. While massing by age is easy, its relevance as the sole criteria is now being challenged. Not all participants at a given age are alike. In fact, the move to customization in larger plans seems designed to recognize that unique personal circumstances and propensities should also be factors. Additionally, not every TDF provider employs the same glide path at a given age. With varying glidepaths and allocations across the industry, how does a plan sponsor know they are choosing the right one for their employees?
The Managed Account Alternative
Using managed accounts is one way to address several of the above issues. Studies show that 61% of 401(k) participants want the personalized advice managed accounts offer.[7] In addition, when using managed accounts, participants tend to save more than when they use a TDF.[8] Lastly, whereas TDFs have a lack of customizability, managed accounts can be unique for each participant.
One factor that has historically been a perceived disadvantage for managed accounts is cost. However, costs vary widely and plan sponsors should consider simply asking cost-related questions rather than assuming which investment option is cheaper. Additionally, a plan sponsor should consider the range of services offered. Cost is often the deciding criteria, but plan costs are now more competitive compared to what they once were[9], and the additional services offered by managed accounts may make a reduced-service, lower-cost plan actually disadvantageous for participants.
Another TDF concern versus managed accounts is flexibility. Managed accounts can adjust asset allocations to changing market environments. While there are exceptions, a traditional target date fund is locked in to a certain annual asset allocation and does not have this flexibility.[10] A prime example of the benefits of flexibility can be found by looking back at the last bear market. From October 2007 to February 2009, the S&P Target Date 2010 index – which would be considered the benchmark for investors in a 2010 target date fund – was down over 26%. This wiped out the entire return the index earned from the end of 2003! Worse, numerous funds underperformed the index, losing a full 1/3 of their value. It is important to remember that 2010 Target Date Funds were purportedly the most conservative TDFs for participants nearing retirement at that time.
‘Take-Aways’
In a nutshell, the retirement landscape is evolving rapidly. TDFs served a very useful purpose in recognizing that participants often do not act on their own behalf. But massing participants along age lines is not an ideal solution for one simple reason: participants are unique. Rather than products designed for an industry or a government mandate, it may be time for plan sponsors to identify and install retirement plans that demonstrate awareness that the central focus has to be on the individual, unique needs and circumstances of each participant. We are going back to the future by developing products and services aimed at doing what plans were always supposed to do: help each participant toward the best possible retirement.
Clayton Fresk is a Portfolio Manager at Stadion Money Management, a participant in the ETF Strategist Channel.