Target-date funds retain luster as DC option

Defined contribution plan assets invested in target-date funds rose 8.6% to $74.9 billion in the 12 months ended Sept. 30, Pensions & Investments' annual survey of the largest retirement plans shows.

Industry experts say that growth should continue thanks to, among other things, the continuing impact of the Pension Protection Act of 2006 and the changing of plan designs.

“This is one of the few (investment) areas getting consistent growth over the last few years,” said Joshua Charlson, senior mutual fund analyst at Morningstar Inc., Chicago. “There's a desire of sponsors to have employees in relatively safer, stable investments.”

Mr. Charlson expects target-date fund assets will continue to increase, although yearly aggregate growth rates gradually will slow as the market becomes more saturated with target-date offerings.

“By and large, I think target-date funds have recovered from 2008 regarding their reputation,” said David O'Meara, a New York-based senior investment consultant for Towers Watson & Co.

(The 2008 stock market plunge's impact on target-date funds, especially those with heavy equity allocations for people nearing retirement, provoked government hearings on the funds' structure, management and marketing.)

“They're not perfect, but they do a good job of providing participants with an appropriate investment at an appropriate time,” Mr. O'Meara said.

The PPA stimulated use of target-date funds because they can be used as a qualified default investment alternative.

“As plans add target-date funds, most plans are making them QDIA,” said Toni Brown, the San Francisco-based director of U.S. client consulting and head of U.S. defined contribution for Mercer LLC.

Plan executives' increased use of auto enrollment has accelerated the use of QDIAs, and re-enrollment also “will drive more assets” to target-date funds, Ms. Brown said.

In the P&I survey, plan executives were asked to identify their QDIA. Of the 48 who responded to the question, 38 cited target-date funds while eight mentioned balanced funds and two, managed accounts.

“There's definitely been a movement from the balanced funds to target funds,” said Mr. Charlson.

For the broad target-date market, Morningstar counted total assets of $378.5 billion as of Dec. 31, excluding assets of custom target-date funds. The average return for the 386 target-date funds tracked by Morningstar was -1.6% last year. The S&P 500 index was up 2.1%.

Morningstar calculated the aggregate asset organic growth rate - which excludes market appreciation - at 15.8% in 2011. Aggregate organic growth rates for 2010 and 2009 were 22.1% and 38.7%, respectively. Even during the depths of the economic turmoil in 2008, the organic growth rate for that year was 33.4%, according to Morningstar.

As the target-date fund industry has matured, plan executives and providers have been exploring alternative asset classes, going beyond traditional equity and fixed income. They're also trying to build in inflation protection and pursuing investments that don't correlate with the general market ups and downs.

In the P&I survey, 41 defined contribution plan executives mentioned Treasury inflation-protected securities as a target-date fund component, while 23 mentioned REITs; 18 cited commodities. Other alternatives mentioned were direct real estate, 8; private equity, 2; and hedge funds, 2.

“Since the (2008) financial crisis, we're seeing more investment managers trying to differentiate their target-date funds,” said Mr. O'Meara of Towers Watson. “They're asking, "Can we build something better?' “

Mr. O'Meara said TIPS are the easiest addition, followed by REITs. Adding other types of investment options depends on the skills of the providers and the willingness of plan executives. One way to offer alternative investments in a target-date setting is to package several investments within a real asset portfolio, he said.

Multiasset-class products like those referenced by Mr. O'Meara “seem to be growing in popularity,” Mr. Charlson said.

Last year, less traditional assets produced mixed results, as noted in a recent report on 2011 target-date performance by the Ibbotson Associates unit of Morningstar. Although TIPS had a 12-month return of 13.6%, commodity futures returned -13.3%; high-yield bonds, 5%; emerging market equities, -18.2%.

Among other observations in the evolving target-date fund landscape, Mercer's Ms. Brown sees more clients considering customized target-date funds, especially among large plans that can use their size to negotiate better prices. Plan officials are developing customized glidepaths based on company demographics, she added.

As the target-date industry matures and as plan executives become more familiar with the fund environment, Jennifer Flodin's clients are showing a greater interest in exploring target-date funds other than those offered by their record keepers, said the co-founder and chief operating officer of consultant Plan Sponsor Advisors, Chicago.

In addition, plan executives are conducting “greater scrutiny” of actively managed target-date funds on fees and performance, Ms. Flodin said.

Among respondents to P&I's survey, Vanguard Group Inc. and BlackRock Inc. were cited most often as target-date fund managers among the DC plans in the survey, followed by AllianceBernstein LP, State Street Global Advisors and Fidelity Investments.

The most frequently cited companies providing DC plan target-date benchmark services were BlackRock, Vanguard, Fidelity, SSgA and Morningstar.