Target Date Funds

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?

DEDOMINICIS: Our stance is that everyone has a level of active decision-making when it comes to the glidepath and the way that you diversify within the various asset classes. Where we think there’s more of an opportunity to decide between passive, active or some combination of the two, is in the underlying implementation of those designs. We have embedded into our investment process the ability to tactically shift, based on our views over a shorter-term horizon, into different asset classes in different sectors. So, obviously, that is an active decision. We recognize that if you think about different asset classes and a portfolio that’s going to be appropriate for multiple decades, it’s important to have some level of active management.

It’s also important for our end clients to have different solutions that have evolved over time. We know that there’s a desire for some plan sponsors to have lower-fee options. As a result, we might have a discussion around a blended strategy that could fit their needs and incorporate the active implementation to add value in some areas underneath the hood. And then, couple that with the right amount of passive in the most appropriate places, so that the result lands at a lower fee.

We are big proponents of making sure that plan sponsors are thinking about all the levers that are available to them for the implementation of a target-date solution — and, as importantly, [thinking about] the impact that each of those levers can have over the long-term for their participants.

OLDROYD: That [active versus passive] is a debate that’s going to outlive all of us. From our perspective, there are several factors that the Department of Labor suggests plan sponsors take into consideration when choosing a target-date fund: the plan objective, asset allocation, performance and fees. That may lead you down the path toward defaulting to passive, but viewed through a fiduciary lens, you want to also ask what type of value you get for the fees. That is where you should be focused — getting the best value. That doesn’t [necessarily] mean the lowest price because the lowest price might come with hidden risks.

Passive investing is not the panacea for everything. There are asset classes that are less efficient and others that are proven to add value. Our perspective is that there is always going to be room for active management. We see a lot of success with a target-date series that combines active and passive and gets you the best of both worlds.

It’s also worth noting that there’s no such thing as a passive target-date fund. The design of the glidepath is an active decision. Just because the glidepath is implemented with underlying index funds doesn’t mean it’s safer from a fiduciary perspective.

P&I: Recent studies have shown that younger employees are more likely to invest in target-date funds than their older peers. What is your perspective?

MILES: There are some nuances in that data. To the extent that a participant has longer tenure at an employer and started before target-date funds were the default, that could lead to numbers that show a fewer number of older workers are participating. With each passing year that has a smaller impact, naturally, because people are either retiring or changing firms. But that’s still clouding the data somewhat.

For younger participants, the important thing is that they participate in the plan. It makes sense that they would be the larger users of target-date funds, since so much of their future savings is ahead of them. But as they age, their balances grow and their circumstances change, they may gravitate toward other solutions that are more appropriate for them.

We’re proponents of participants seeking additional help for their circumstances as they change. That could be what’s driving some of that transition away from target-date funds as people mature. We don’t think that will change, as target-date funds are an ever-present feature of the DC marketplace and will likely persist for quite some time.

OLDROYD: [The studies] are perfectly congruent with the life cycle of what you’d want in a target-date fund. When you think about it, your 25-year-old is going to have a lot more in common with another 25-year-old than two 60-year-olds. [Those age cohorts] could be on two very different paths.
The popularity of TDFs among younger workers also speaks to the idea that there’s still room for the “do-it-for-me” solutions out there. Younger cohorts have gotten very comfortable with automatic features, such as auto-enroll and auto-escalation — that means you can probably go even further, and they might be more likely to stick around and stay in these strategies as they go forward.

P&I: On the other end, there’s a need for retirees to stay in the plan after they’ve finished working. What challenges does this group pose, and how else can TDFs serve retirees?

MILES: More and more plan sponsors are trying to answer exactly this question. The recipe for success is well known on the accumulation side: auto enrollment gets people into the plan and gets them saving. Auto escalation gets them saving more over time. That works well up until retirement.

But those auto features don’t really exist on the decumulation phase, and it’s important that we evolve DC plans to think about that, because people don’t necessarily become more engaged when they’ve retired. Data shows that people have greater difficulty making financial decisions over time in retirement, and they are being asked to make some really difficult decisions that they may not be equipped to answer: What will my assets return over the next number of years? How much do I need to live off of, and how much can I safely withdraw? It’s much more difficult than a stock-bond allocation.

In the decumulation phase, target-date funds need to help in the same way that they help with accumulation. That would help improve outcomes for the large majority of DC plan participants. While it wouldn’t be perfect, it would be a lot better than what we see today.

Right now, people automatically defer part of their income into their plan on the accumulation side, but the same thing doesn’t happen in reverse, whereby they start automatically drawing down their assets in retirement. Just as plans make assumptions on the accumulation side, they need to make assumptions on the decumulation side. For example, they might assume a 3% or 5% draw down, with dual life expectancy into the early 90s for plan participants.

DEDOMINICIS: We encourage our clients to engage sooner with retirees and near-retirees, and to establish a communication plan to help them understand the value of staying in the plan, whether that’s fee-oriented or the fiduciary oversight piece, and to inform them that they do not have to roll out their plan assets.

For some plan sponsors, the first thing an individual gets when they’re nearing retirement is the paperwork to roll the assets out. It’s important for sponsors to take a step back and revisit their plan documents to allow for systematic withdrawals or partial distributions so that there’s some flexibility there.

That needs to start in the preretirement phase. Don’t wait until participants already have another plan in place, or they’ve tapped into this idea of rolling assets out. You must inform them [sooner] about the benefits [of keeping assets in plan]. If we start engaging with our participants sooner, it can become a very important aspect of treating the DC plan as a destination account.

P&I: Target-date funds have been around for over two decades. How do you see them changing over the next five years?

MILES: We’re going to see target-date funds more readily include additional asset classes on a go-forward basis. We broadened the underlying equity exposure to include emerging markets and non-U.S. small caps about a decade ago. Around the same time, we started to include real assets to help manage inflation risk. But there hasn’t been a ton of further broadening of the underlying asset classes, and we think that could happen [with] the use of private investments, particularly on the custom target-date fund side, but perhaps even more broadly.

The other way that target-date funds might evolve is with respect to how glidepaths are managed. Target-date funds, even through the COVID time period, did well because bonds and stocks were inversely correlated. Stocks went down and bonds provided meaningful — although not perfect — diversification. But that hasn’t always been the case. If you go to the pre-dot-com bubble in the ’90s, that was a period when stocks and bonds had a positive correlation.

So the question is, how will the majority of target-date funds survive, potentially, in an environment where correlation between stocks and bonds is not perpetually negative? And how would that change the experience of target-date funds on a go-forward basis?

DEDOMINICI: One area where we have continued to see demand from plan sponsors and advisors is customization and personalization. Target-date funds have been very effective at addressing a lot of the issues that are driving retirement outcomes, but one of their advantages is also one of their shortcomings: they’re built for homogenous populations and, therefore, when it comes to personalization, it’s a more challenging to address for individuals.

We’ve been spending a fair amount of time on being able to offer the ability to be a little more personalized. We’re working on building out a capability where we are leveraging technology as well as the record-keeper system to deliver a much more personalized solution to those individual participants.

Looking ahead, I would expect that this [personalization of target-date funds] will be more widely adopted. We think it’s beneficial to have the capability to take individual inputs, rather than population parameters and provide a more personalized approach so that individuals will be able to have a solution that’s specific to their inputs. Our goal is to offer journey management for participants to and through retirement.

OLDROYD: Plan sponsors and consultants have really shown an increased desire to keep employees in the plan after they retire, and regulatory shifts [that support retirement income offerings] can take some time to play out. The Pension Protection Act passed in 2006, but we didn’t see the ball rolling downhill until 2009 or 2010. I think we’re at the same precipice with respect to retirement income now with the Setting Every Community Up for Retirement Act (SECURE Act) of 2019, and we may see more from SECURE 2.0. From our perspective, we expect target-date funds to play an increasing role in addressing retirement security at both the plan sponsor and participant levels. ■