Roger Wohlner is a target date fund skeptic. A fee-only financial advisor for both retirement plans and individuals, Wohlner worries that target date funds — which invest in a mix of assets with the aim of reducing equity exposure as participants approach retirement — just can't do as good a job as professional advisors managing client funds.
“I have mixed emotions about them,” says Wohlner, whose firm, Asset Strategy Consultants, is based in Arlington Heights, Ill. “They're better than just leaving your funds in a money market fund for 30 years, but you really can't just ‘set it and forget it.’ Investors need to focus on how the target date fund fits into an overall financial plan.
“I can't imagine that most advisors doing comprehensive work for a client wouldn't take a look at the 401(k) plan and advise the client to put some of their money into open funds instead of a target date fund,” he adds. “That gives you more control over the asset allocation, and the ability to fine-tune it.”
Wohlner's views are typical of many advisors, who worry about target date fund (TDF) glide paths, asset selection and allocation, risk and too-high fees. And their concerns have been borne out by some recent history of TDFs. Many fund series came under heavy fire following the 2008 market crash when they failed to adequately protect older retirement investors.
Yet TDFs are here to stay — if anything, they're becoming the 800-pound gorilla of the workplace retirement market. A report issued last month by BrightScope and Target Date Analytics indicates that TDFs now account for 10 percent of total invested assets in workplace plans, a figure that is expected to top 28 percent by 2020. And Vanguard reported recently that 79 percent of the plans it administers offered TDFs last year, up from 13 percent as recently as 2004. Likewise, 42 percent of Vanguard plan participants used TDFs last year, up from just 2 percent in 2004.
The sharp growth is tied closely to the rise of auto-enrollment options in workplace plans. The Pension Protection Act of 2006 amended the Employee Retirement Income Security Act (ERISA) to provide a safe harbor from liabilities associated with participant investing for plan fiduciaries who adopted certain automatic enrollment features, and subsequent rule-making designated TDFs as a default Qualified Default Investment Alternative (QDIA) under the new law.
But TDFs aren't just getting bigger — they also seem to be getting better.
The BrightScope study finds that the industry is moving toward a more conservative posture on the critical issue of fund series glide paths — that is, the year targeted for the lowest exposure to equities. “Funds can take very different approaches to the glide path,” explained Brooks Herman, BrightScope's head of research. “Sometimes the landing date can be many years past the target date in the fund name.”
The BrightScope study finds that 40 percent of TDFs are now using a “to versus through” approach to glide paths, up from 30 percent as recently as 2007. That means the most conservative asset allocation is reached in the year of the fund series name. “We like that, because it's truth in advertising,” says Herman. “As an investor, I know what I'm getting.”
The study's glide path findings are consistent with an analysis by Morningstar in August, which found that losses during the summer market meltdown were far less severe for 2010 and 2015 TDF series than losses were for those funds in 2008. Morningstar calculated the percentage of the S&P 500 loss sustained by both TDF series, creating a comparative loss ratio that effectively measures how much of the overall market loss was absorbed by the target date funds.
The results point to improvement in managing equity exposure for investors close to retirement; the 2010 fund series had a loss ratio of 43 percent this year, compared with 60 percent in 2008, while the 2015 fund series had a loss ratio of 55 percent, compared with 74 percent in 2008. Morningstar credits the improvement to greater risk control, particularly in shorter-dated funds, through hedging strategies.
The BrightScope report also finds that fees have fallen in the past year, but remain “too high.” While institutional funds had average expense ratios of 75 basis points, moves by Vanguard to introduce TDFs that charge an industry-low 18 basis points prompted Fidelity Investments and TIAA-CREF to respond by introducing funds with expense ratios of 19 basis points. “That is a real reaction to what Vanguard is doing,” Herman said.
The BrightScope study, called Popping the Hood, is being marketed to plan sponsors, asset managers and advisors. It grades target date series on five criteria: performance, fees, risk, organizational structure and strategy. Researchers analyzed 48 fund series, but graded only 38; those were the fund series old enough to have three years of operating performance data.
The top-rated fund family is American Century Investments' Livestrong Portfolios. Four other fund series received an “A” grade: Wells Fargo Advantage, MFS Lifetime, J.P. Morgan SmartRetirement and Vanguard Target Retirement. Another seven funds received “B” grades.
Keep these points in mind when working with clients who are using TDFs:
Automation beats some alternative approaches. Morningstar research shows that investors who use all-in-one “set it and forget it” vehicles often do better than those who actively move in and out of funds as the market fluctuates. For example, Morningstar found that in the last decade, balanced fund investors earned a 3.36 percent annualized return, compared with 2.74 percent for the average fund. Although TDFs are too new to measure accurately across a 10-year period, Christine Benz, director of personal finance at Morningstar, notes that TDFs are a sub-set of the balanced fund category, and that performance comparisons to date are similar to those for balanced funds.
“A mix of bonds and stocks leads to moderate results, and more investors stick with these funds through the down periods,” says Benz,.
“In theory, it shouldn't matter if you hold a stock fund and a bond fund separately or get the same exposure through an allocation fund, but in practice it seems that boring balanced funds don't push fear or greed buttons that throw people off,” she adds. “As Jack Bogle says, emotion is the enemy of the investor.”
See the big picture. “A target date fund can't know what's going on overall with the client,” says Benz. “Does the client have a lot of assets, or just a few? Is there a pension to draw on in retirement, or higher-than-average Social Security benefits? That might call for being heavier in stocks than the TDF allocation.”
Adds Wohlner: “You have a client participating in a workplace plan, but maybe there's a spouse with an old 401(k) somewhere or an IRA, or a taxable account. So, you need to look at the TDF's allocation and factor it together with the outside assets.”
What's inside the TDF? “You have to evaluate and really dig into it to be sure the TDF series matches the behavior and risk tolerance of the participant,” says Ryan Alfred, Brightscope's co-founder and president. For example, no industry standards have been adopted for fund naming. Analysts at Morningstar and elsewhere have criticized a lack of disclosure and transparency on matters such as glide-path allocations; reforms have been proposed both by the U.S. Department of Labor and the SEC aimed at addressing concerns about TDF naming, marketing and disclosure.
What happens after retirement?Benz says TDFs are a poor vehicle for retirees who are liquidating and spending down assets. “When you retire, you need to segregate cash from bonds and equity holdings, so that you can make strategic decisions about when to sell from each asset class.” Although Benz expects TDFs will start to address that problem, currently the industry doesn't offer solutions to that problem.
Mark Miller is a journalist and author who writes about trends in retirement and aging. Mark edits and publishes RetirementRevised.com, which has been recognized by Money magazine. He also writes “Retire Smart,” a syndicated weekly newspaper column, and contributes weekly to Reuters.com. He is the author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work and Living (John Wiley & Sons, 2010).