Target-date fund growth likely to continue

Changes in plan design are responsible for strong 29% increase in the strategy

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Sustainable: Kevin Chisholm says growth in target-date funds looks sustainable

Defined contribution assets invested in target-date strategies climbed nearly 29% to $96.5 billion in the 12 months ended Sept. 30, according to the Pensions & Investments' annual survey of the largest retirement plans.

Defined contribution and target-fund experts say the growth should continue, fueled in part by more plans offering the funds but more significantly because of plan design features that encourage greater target-date fund investing — such as qualified default investment alternatives, auto-enrollment and re-enrollment.

“The growth looks sustainable,” said Kevin Chisholm, associate director of Cerulli Associates in Boston.

“We will see more cannibalization of other asset classes (in DC plans) as people get more comfortable with target-date funds and sponsors provide more education and communication,” said Brooks Herman, director of research at BrightScope Inc., San Diego. Core bond funds and domestic equity funds are the most vulnerable, he said.

Target-date funds are taking a bigger piece of plans' average asset allocations, according to P&I survey data. In the latest survey, target-date funds represented 11.6% of aggregate assets among the DC plans among the top 200 overall vs. 9.6% for the year-earlier survey.

Among the largest corporate DC plans, target-date funds accounted for an average allocation of 10.9% within the asset mix vs. 9.5% in the previous survey.

Among the largest public DC plans, the average asset mix for target-date funds was 10.4% vs. 5.4%. The huge jump is explained in part by a boost in the target date allocation of the Washington State Investment Board, Olympia. The board, which ranked third among public DC funds with $11.53 billion, reported 22% of assets in target-date funds as of Sept. 30, up from 8% a year earlier.

Of the 60 plans identifying their qualified default investment alternative in the latest survey, 49 cited target-date funds, nine referenced balanced funds and two mentioned managed accounts. In the previous survey, 38 of 48 plans cited target-date funds as QDIA, while eight cited balanced funds and two cited managed accounts.

“Our research shows target-date funds are the most popular QDIA,” said Winfield Evens, a partner at Aon Hewitt, Lincolnshire, Ill. “We expect target-date funds will be a dominant — not just a large — component” of DC plan assets.

Target-date funds will gain market share vs. target-risk, or balanced funds, within DC plans “because they are a more elegant” asset allocation model, Mr. Evens said. “They offer good asset allocation for the average participant.”

He added target-date fund asset growth will be enhanced when more sponsors are comfortable integrating lifetime income options within the funds. “We still need greater clarity from government,” said Mr. Evens, referring to many plan executives hesitating to use lifetime income options without a definitive safe-harbor ruling by the Department of Labor.

Managed glidepath

Cerulli's Mr. Chisholm predicted target-date growth will be aided by participants contributing at a higher rate and by younger workers who are becoming more amenable to accepting a long-term managed glidepath rather than pursuing active investing.

To illustrate his belief in the youth movement, Mr. Chisholm cited research published in December by the Investment Company Institute, Washington, showing that among 401(k) participants in their 20s, the average allocation to target-date funds placed second only to equity funds.

Using 2011 average-account balance data, ICI said the average asset allocation was 32.8% for equity funds and 31.3% for target-date funds for people in their 20s; balanced funds accounted for 11.2% of assets.

Among all age groups — 20s through 60s — target-date funds represented an average asset allocation of 13.3%, according to ICI. Equity funds represented 39.2% and balanced funds, 7.2%.

“There's still room for growth,” said Josh Charlson, senior mutual funds analyst and target-date fund strategist for Morningstar Inc., Chicago. He cited lower fees, index-based funds and new strategies as sources of increased interest in target-date funds. “This is still a growth industry, although not like it was years ago.”

Morningstar calculates that target-date fund assets — excluding assets from custom target-date funds — climbed to $484.8 billion at the end of 2012, up 28.1% from the $378.5 billion in 2011. The average return for the target-date funds in Morningstar's universe was 12.72% last year. The S&P 500 was up 13.4%.

Mr. Charlson and his peers cited alternative investments as continuing to play a role in target-date fund construction even if some alternatives — such as real estate investment trusts and Treasury inflation-protected securities — are becoming increasingly common.

Among 49 plans identifying alternatives within their target-date funds, the P&I survey found 47 featured TIPS, 27 had REITs, 26 included commodities and 11 featured direct real estate.

A handful of pension plans reported having private equity, annuities and/or hedge fund-of-funds components in their target-date funds. Many plans' target-date funds had more than one alternative component.

In the year-earlier survey, the most popular alternatives in target-date funds were TIPS (41 plans), REITs (23 plans) and commodities (18 plans). Forty-four plans reported at least one alternative.

Grew 100%

A growing number of money managers have been marketing direct real estate investments for defined contribution plans, mostly through target-date funds. But like other alternative investments, the main stumbling block is the asset class' illiquidity, said Peter A. Lewis, senior consultant in the New York office of Towers Watson Investment Services Inc., a research subsidiary of Towers Watson & Co.

As a result, many of these direct real estate strategies are including REITs.

Despite the challenges, Dave Esrig, managing director and portfolio manager for J.P. Morgan Asset Management (JPM) in New York, said its direct real estate fund — designed for target-date funds — grew 100% to roughly $400 million in the year ended Sept. 30.

“It's a substantial business for us and is an important way to bring direct real estate to existing defined benefit customers,” Mr. Esrig said. “We view it as our fiduciary responsibility to bring the broadest array of asset classes to the defined contribution participants as well.”

J.P. Morgan executives do not think direct real estate is an appropriate stand-alone investment option for defined contribution plans, he said. “Target-date funds put a professional intermediary between the participants and the illiquid assets,” Mr. Esrig said.

Arleen Jacobius contributed to this story.

This article originally appeared in the February 4, 2013 print issue as, "Target-date fund growth likely to continue".