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Target-date funds deserve 5 stars

Target-date strategies are on a roll, and there's little reason to think that's going to reverse anytime soon. Data from Pensions & Investments' most recent DC money managers survey show that target-date assets grew to a whopping $1.44 trillion for the year ended Dec. 31. That represents a 30.5% surge, far outstripping the 10% growth in the prior year. And they're increasingly the investment choice among retirement plan participants.

According to Vanguard Group's 2018 report on clients' investing behavior, "How America Saves," 51% of represented defined contribution plan participants held a single target-date fund for all of their plan assets. For younger workers, the percentage is much higher.

Credit the Pension Protection Act of 2006 for the growing embrace of target-date strategies.

The act established a safe harbor for plans that include auto-enrollment features. That feature requires participants to opt out if they don't want to contribute to their retirement plan, a strategy that rests upon the idea that participant inertia is a hard force to overcome.

Because the act also gave plan sponsors the opportunity to move participants into target-date strategies as a qualified default investment alternative, more sponsors have been choosing to do so if members don't elect an investment option. The Vanguard report noted that among plans designating a QDIA, 96% use target-date strategies.

There's something to be said for that approach. Left to their own devices, participants have been known to load up on company stock, go too heavy into equities or leave too much money in cash or its equivalents. With a target-date strategy, the thinking goes, participants can be placed into investments that attempt to provide a blend of strategies to provide diversification and, hopefully, capture investment returns.

That's not to say target-date strategies are perfect.

Some industry experts have raised questions about whether participants understand the risk of these investments — namely, that equity risk is still present — or if they have been lulled into a false sense of security, given the default status granted by the employer.

Critics also point to the very real pain that many participants enrolled in 2010 target-date funds experienced as a consequence of the global financial crisis.

As P&I reported in 2009, an investigation by the Senate Special Committee on Aging found that various mutual fund companies had wildly different asset allocations between equities and fixed income in 2008, with many of the 2010 funds investing more than half their assets in stocks.

Should another market correction occur, some unlucky participants could take an especially tough punch if their retirement date happens to coincide with the correction, some critics have said.

Whether the target-date strategy operates to or through retirement is an important distinction. A large helping of equities does make sense if the strategy is through retirement.

The good news is that defined contribution plan participants who use managed accounts or target-date strategies enjoy better investment returns net of fees than participants who invest on their own, a recent survey by record keeper Alight Solutions said.

Over a 10-year period through Dec. 31, 2016, Alight found that the average annualized return for participants consistently using managed accounts was 3.66%; the average annualized return for "consistent full" target-date fund was 3.65%; and the average for consistent non-users was 3.39%, according to a survey report.

Alight defined a consistent user as someone enrolled continuously for the three-, five- and 10-year periods that were part of Alight's analysis of data.

Fees, too, are falling.

The average asset-weighted expense ratio for a target-date mutual fund series fell to 66 basis points in 2017, making it the ninth consecutive year the ratio has declined, Morningstar's latest annual survey of target-date funds released in May said.

The survey found the average expense ratio for 2017 was down 5 basis points from 2016 and down 37 basis points from 2009. The report's authors attributed the continued fee decline, in part, to "the injection of more passive exposure within historically active target-date series and the launch of series that blend active and passive funds."

Can target-date strategies be improved? Undoubtedly. But when combined with the features of auto enrollment and auto escalation, they serve to fight employee inertia and get people on the way to saving in a diversified, cost-efficient way for their retirement.