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Retirement plan sponsors continue to favor target-date funds as a default option, for good reason. As auto-enrollment and auto-escalation boost individual retirement accounts, target-date funds do the asset allocation and rebalancing to ensure well-funded retirements.
Target-date mutual funds continue their multi-year trend of strong growth, with assets reaching an all-time high of $880 billion at the end of 2016. More providers offer them, as well: While three top managers continue to hold the lions share of target-date assets, at the end of 2016, 12 firms offered more than one target-date series, catering to a variety of clients, whereas ten years ago, no firm offered more than one, according to Morningstar.
In addition to their growth and proliferation, target-date funds have evolved in response to investor preferences and an increased focus on longevity. When the first target-date funds came onto the market in the early 2000s, the general view was to focus solely on what happens at retirement, says Wyatt Lee, portfolio manager, target-date solutions at T. Rowe Price. The idea was to invest in a defined-contribution (DC) plan for a period of time to build a pool of assets; at retirement, the wealth accumulation game was over, and it was time to be defensive by preserving wealth. Now, many DC plans recognize that peoples savings require reasonable growth to support a potential 30-year income stream in retirement, he says.
The key evolution of such plans is to provide the investment growth needed to fund todays longer retirements. Target-date funds have been evolving in terms of investable asset classes, capital market expectations, and demographic shifts, including increased longevity, says Nick Nefouse, head of the DC investment and product strategy team at BlackRock. We have done a lot of research into income patterns and spending preferences, he adds.
Furthermore, the complexity of target-date portfolios has evolved. Originally, non-U.S. exposure was simply to developed markets, which subsequently expanded to include emerging markets and international small-cap. Its been an iterative process of widening out the opportunity set to provide the best risk-adjusted returns, says David Ireland, global head of defined contribution at State Street Global Advisors. Inflation-hedging assets are now part of the mix. Theyre really important, especially when heading into retirement, when retirees need to maintain their purchasing power, he says. Inflation is a looming risk, and overall, the DC industry is underexposed to inflation-protected asset classes.
Target-date fund (TDF) offerings have become more diversified, as well. Early on, the underlying target-date strategies were pretty vanilla, says Lee, with mostly large-cap U.S. stocks on the equity side and investment-grade U.S. bonds on the fixed-income side. As the market became more comfortable with the TDF concept, portfolio managers had a greater degree of freedom, with more diverse strategies being implemented. On the equity side, target-date funds invest across a range of capitalizations and styles; they are more global; and they include inflation-sensitive instruments. On the fixed-income side, they invest globally; include high-yield; and use more specialized strategies to manage duration risk. We continuously evaluate each element of the portfolio and deploy more sophisticated and precise levers to respond to market conditions, Lee says.
The art of the target-date fund is understanding how to blend financial assets or savings with a participants ability to work, and to adjust the weighting over time. Implementing that appropriate glide path is critical. Using the wrong glide path means that participants will either need to save more or take unnecessary risk over their lifetimes to get to a similar outcome, says Nefouse. The aggregate amount of risk taken across the glide path is ultimately what drives outcomes. At which point in time the glide path takes risk is as important as the amount of risk it takes, he says. Without a glide path, we have merely a balanced fund. The glide path inputs explicitly connect the fund to an individuals income, and how that income changes over a lifetime.
Early versions, first introduced 20 years ago, were launched with ten-year age bands, but now theyre available in five-year increments that participants can correlate more easily to their retirement dates. Another key difference is the evolution of the glide path: Now there are a range of glide-path options, and plan sponsors can choose which one best meets the needs of their plan participants. For example, some funds are focused primarily on providing lifetime income, and others are focused on protecting assets around the time of retirement. Weve seen these different objectives grow and evolve in the market over time, says Lee.
While target-date funds are designed to be a participants sole menu option, many participants use them in combination with other investment vehicles. The glide path is designed in a specific way, based on capital-market expectations, longevity assumptions at a given age, and expectations for future income, says Nefouse. Target-date funds are complex instruments calibrated to provide a reasonable range of expected outcomes. However, Using them in combination with other investment options can radically alter a participants risk profile in ways that most non-professional investors may not be able to anticipate, Nefouse says.
Improving Savings Rates
Adequate savings rates are a prolonged challenge for American workers. The average retirement account for a 55- to 65-year-old is only about $104,000, says Ireland, of those households with access to employee-sponsored retirement plans. Furthermore, prolonged periods of low interest rates have led to lower long-term return expectations across traditional asset classes, and younger generations will have to save a larger share of their income to generate the same level of retirement readiness as their older counterparts. Target-date funds do a great job of moving people through the wealth-accumulation savings years, he says. TDFs are designed to provide a diversified portfolio of traditional assets with age-appropriate levels of risk. Asset allocations are rebalanced from mainly growth assets to mainly income assets, following a glide path over a long-term horizon.
However, at retirement, many individuals who rely on their DC investments as their primary source of savings are challenged with translating that accumulated wealth into a steady income stream. The onus is on the participant to figure out what that asset base will support in terms of monthly or annual post-retirement income, and how to convert that asset base into that steady income, says Melissa Kahn, managing director of retirement policy strategy at State Street Global Advisors. We call it the wealth illusion.
Many see a pot of money more than theyve seen in their lifetime when they have been used to receiving a regular paycheck. Translating the principal into sustainable income can be challenging. Theyll either overspend or underspend as a result, because they have no idea of their mortality, Kahn says. It can be challenging to manage this process effectively, and the industry is working with legislators and regulators to address this issue. One initiative, now in Congress, would mandate a lifetime income disclosure statement to indicate how a current retirement account balance translates into monthly income. Its a real wake-up call when plan participants see that their $100,000 savings at age 65 would translate into only $400 a month, says Kahn. Its an astounding point of reference for most people.
The well-known strategies of auto-enrollment, auto-escalation, and reenrollment remain essential to help boost participant savings, but even when considering innovations in DC, there continues to be an effort to get the most out of the available tools. BlackRock is leveraging technology at the plan level and in participant engagement to help drive decisions, says Nefouse. With that in mind, sponsors can drive appropriate changes to boost savings rates, improve diversification, and build retirement income potential. With participants, we incorporate communication techniques from outside our industry, such as interactive video, that enable participants to get targeted messaging that helps them take appropriate next steps for their situation, he says. These tech-enabled approaches to communications allow for increased personalization, while remaining simple for the sponsor to implement.
There are other ways that DC providers can help and encourage plan participants, says Nefouse. One is to attempt to cushion volatility for participants near retirement so they dont pull out of the market at the wrong time after a loss. Providers can also try to shift participants attention away from the current dollar value of their account toward a focus on how to achieve sustainable retirement spending targets. In addition, participants can be encouraged to focus attention on what they can control, such as how much they save and their retirement planning, and less on the day-to-day market.
Savings habits vary among generations. Gen-X and boomers arent as accustomed to auto-enrollment and other auto features that have evolved, versus millennials, who have been opted in, and they tend not to opt out, says Lorie Latham, senior defined contribution strategist at T. Rowe Price. Millennials tend to stay in DC plans, although often just at the default rates, which remain low, and in the default options, which are target-date funds. Longevity is one of the key components that target-date funds should solve for, Latham says. Longevity isnt necessarily on the minds of millennials, but TRPs target-date solutions are designed to address longevity by maintaining opportunity for growth into retirement.
Target-date funds growth and popularity are largely due to their role as the default investment option in most DC plans, as the benefits of target-date funds address many of the issues that face DC plan participants. Pre-retirees and retirees both are developing a greater awareness of longevity, says Latham. Pre-retirees need to manage the planning processhow best to save, build wealth, and decide what will be enough to retire onwhile retirees must focus on how to generate income. Both groups wonder if their lives will outlast their money, she says.
Auto-enrollment and default options aside, target-date funds present a strong value proposition. Participants value the broad diversification, automatic rebalancing, and programmed de-risking elements, says Ireland. Furthermore, fees have come down quite a bit across target-date funds as they become a larger percentage of plan assets. A big portion of the inflows can be attributed to the fact that target-date strategies are deemed to be the optimal solution for the majority of DC investors, which is why theyre typically the default, he says.
Indeed, target-date funds provide plan participants with access to a sophisticated, diversified product for a single fee. Beyond fees, there is also a cost associated with a participants time. BlackRock is very much aware of the fact that the more time an investor spends worrying about asset allocation, rebalancing, and other complex portfolio management problems, the less time that investor has to be a mother, a father, a sibling, or a friend, says Nefouse.
With the race to the bottom with respect to fees over the last decade or so, especially among passive funds, looking primarily at fees is the wrong way to select a target-date fund provider. Such decisions are better made on a holistic basis that considers many factors, as retirement outcomes are fundamentally determined by all the elements of product design. The performance of a well-designed target-date fund that captures more upside, avoids more downside, and delivers the risk-return ratio that it seeks to achieve will, in the end, be a greater deciding factor, Nefouse says.