In the 15 years since the Pension Protection Act designated the use of target-date funds as a qualified default investment alternative, they have come to dominate workplace defined contribution plans. Even amid the volatility of the COVID-19 pandemic last year, overall TDF assets continued to grow strongly, largely due to market gains. As TDFs continue to evolve in ways that help improve the retirement outcomes of participants and retirees, how can plan sponsors best evaluate current structures? To learn the latest on how plan sponsors can meet their plan objectives with TDFs, Pensions & Investments spoke with Daniel Oldroyd, portfolio manager and head of target-date strategies at J.P. Morgan Asset Management, Kim DeDominicis, portfolio manager at T. Rowe Price, and Nate Miles, head of defined contribution at Wells Fargo Asset Management.
Pensions & Investments: While most target-date fund investors in DC plans stayed the course throughout the volatility of the last year, outflows did pick up significantly. What does that tell you about the suitability of TDFs as the default for retirement plans?
NATE MILES: If we focus too much on the outflows, we’ve glossed over the overwhelming data that showed that the majority of participants actually stayed the course. Target-date funds really delivered on their overall objective to provide a diversified suite of underlying investments, and they did it really well. The important thing is not just that the funds did well, but also that most people behaved as we would want them to behave, which is that they didn’t do much. Based on that premise, target-date funds continue to be one of the greatest innovations in the DC space over the past two or three decades.
That said, the research that we’ve seen shows that that when participants did make withdrawals, it was because they were exiting the workforce, changing employers or rolling assets over into another plan.
DAN OLDROYD: The outflows really come at the end of the glidepath, closer to retirement. We have research from a few years ago that tells us that about 72% of participants draw down their assets within three years of retirement. I expect you’ll see that number decrease over time, and more people will stay in their plan. But this is clearly a point of inflection.
Overall, the performance of target-date funds over the past year has shown that they’ll continue to flourish. They’re the dominant form of default in DC plans because they’re a simple, elegant solution to a hard problem: How do you save over four or five decades [in order] to have enough money to last several more decades?
KIM DEDOMINICIS: Another reason that we saw some outflows was that there were several provisions in the [Coronavirus Aid, Relief and Economic Security] Act that probably made it easier for people to take money out of their retirement funds if they needed it.
But, overall, we still see target-date fund participation increasing, and the amount that participants put into their accounts is increasing. So while some individuals took advantage of those CARES Act provisions, many stayed the course. That happened even though some people were probably panicking as the market dropped quickly in the first quarter of 2020.
From our perspective, 2020 proved that target-date funds are really serving the participant base very well. We’re more up against [the need] to solve for emergency savings, so that participants have another option to draw down versus having to tap into their retirement account.
P&I: Given the prevalence of target-date funds, how can plan sponsors select the most appropriate one for their plan? How do you ensure their plan philosophy aligns when it comes to the glidepath or fund selection?
DEDOMINICIS: We approach it as a partnership with our clients. We make sure that it’s very clear that we are solving for that long game [to retirement], which is very complex, [and] that we want to make it as simple as possible for the end participant. We work with the clients to determine their overall objective, so we can have a detailed discussion about the type of portfolio solution that’s most appropriate for them.
We start with the idea of defining risk, which comes in many forms for defined contribution plans. While all risks matter, we want to help our clients think about the risk hierarchy for their own unique plan circumstances and let that guide the glidepath assessment.
For example, if a client tells us that solving for longevity risk is their highest priority, we define that as ensuring their participants will not have a shortfall in retirement; so we might encourage them toward a higher-growth glidepath, having higher equity up to and through retirement. On the other hand, if they indicate that downside protection is of greatest focus, then we would likely guide them toward a more moderate growth glidepath and maybe bring down the equity exposure a bit.
At the end of the day, just calibrating to the way clients think about that risk profile is critical, and it’s something that we spend a lot of time breaking down. We talked about the equity piece, but there’s also risk around participant behavior and inflation risk. We get into the difference between downside risk and volatility risk. Volatility goes up and down. When it’s up, no one complains; when it’s down, everybody complains.
OLDROYD: [Selecting the target-date fund] is probably one of the most important fiduciary decisions that the plan sponsor or their advisor is going to make. There are more than 40 different flavors of target-date funds and it really comes down to, what are you trying to achieve on behalf of your plan and your participants? To make that determination, you need to understand what your participants are doing and how they’re saving, borrowing, and spending.
This understanding is key, because as a plan sponsor, you should select a glide path that is aligned with both the objectives and demographics of your plan. Then, after you’ve selected a target-date fund, you go back and monitor it to ensure it continues to be suitable in those contexts.
P&I: Custom target-date funds have become popular in recent years, and they vary significantly within vintages and asset allocation. How do you help plan sponsors evaluate custom funds?
MILES: It starts with the plan sponsor’s objectives, both to and through retirement, and how they want to balance the need to grow, protect and, eventually, generate income from those assets for their participants. After we understand their objectives on the to- and through-retirement sides, we’ll look at their data to understand how it’s similar to or different than the average.
The average target-date fund makes several assumptions that may or may not be relevant for a particular plan or participant. If all the plan sponsor’s data aligns with the average, then they can probably go with an off-the-shelf plan. It’s when the objective or the underlying data starts to change that we really look to start to evolve the glidepath.
There are also fee considerations as we’re building these funds. Is the lowest price important to the plan sponsor, or are they willing to consider active asset classes or even asset classes that might be less traditional in the DC space? As we understand those characteristics on the asset class side, we can start to build out a glidepath that might be different for each plan sponsor.
Often, the plan sponsors that are looking for custom solutions also have an active defined benefit plan, or most of their participants have access to DB benefits, in addition to Social Security. Another factor in favor of a custom plan would be if the participants have achieved high savings levels or if they’re retiring much earlier than usual.
OLDROYD: Custom can mean a lot of different things. When we have conversations with plan sponsors about custom, we refer to a glidepath that is built for each specific XYZ company that will most likely use the investments from XYZ pension plan. So plan sponsors need to ask themselves whether they have the in-house expertise or desire to do their own manager selection. Do they have economies of scale? Is their demographic profile different enough from other available glidepaths?
There are pros and cons to custom funds, but it comes down to whether the plan is different enough or has different objectives that would necessitate custom. Is there something that’s driving them to say, ‘We are going to do our own version.’ There are 40 or 50 different types of target-date funds available today, so you can almost always find an off-the-shelf glidepath that matches what you need.
P&I: Given different manager strategies and varying glidepaths, benchmarking remains a challenge for the target-date industry. What’s your approach to it?
OLDROYD: Benchmarking for target-date funds requires a little more time and effort than traditional benchmarking. With a large-cap U.S. growth equity fund, for instance, you’re going to compare it to the Russell 1000 Growth. You can compare its performance in a pure universe and know that you’re either getting what you need from a price perspective or performance perspective.
Target-date funds are different in terms of benchmarking. Once you’ve settled on an objective for your target-date fund, you can narrow the universe of the target-date funds that fit that philosophy and, from there, determine how your target-date fund is executing for the plan [on a comparative basis]. However, the [investment horizon] for target-date funds is decades long. As a fiduciary, you need to balance short-term performance versus the long-term goal of the glidepath.
In addition, some target-date funds may place more emphasis on getting people over the finish line at 65, so perhaps they will have lower levels of equity. When you compare these funds against peers, you should keep in mind that three out of four target-date funds might be oriented toward something that’s more aggressive [and] that can make peer group comparison challenging in the short-term.
We try to evaluate the success of our target date funds relative to a composite or custom benchmark, which can be a proxy for how your glidepath is performing. How did we do against the glidepath? Is the glidepath itself on track to meet its objectives? How does it compare against peers over the long-term? We also keep an eye on some third-party benchmarks. From there, it’s really a mosaic [of data points for benchmarking].
For plan sponsors, that can mean spending a large chunk of your committee meeting reviewing benchmarking data in order to get a complete picture of how your target date funds are performing.
P&I: How do you think about the active-versus-passive debate when it comes to target-date fund allocations?