Trends in Target Date Fund Investing
Since their inclusion as a qualified default investment alternative (QDIA) under the Pension Protection Act of 2006, target date funds (TDFs) have seen an explosion of growth, with assets topping $1 trillion in 2017 (1). This unprecedented growth has resulted in TDFs playing an important role in the retirement success of a growing number of investors. TDF growth is primarily due to the appeal of professional management of a participant’s asset allocation, fund selection, and glidepath. With a TDF, a participant can adopt a “set-it-and-forget-it” approach to retirement investing, since the fund’s manager selects the underlying funds and adjusts the asset allocation over time to become more conservative as the participant nears retirement.
Historically, investment managers offered TDFs with traditional investment styles that were invested in their own underlying investment funds. Recordkeeper’s proprietary target date funds were also heavily utilized. As the adoption and popularity of target date funds continues to expand, so have the diversity of TDF offerings. Today, plan sponsors can select from a universe of options to best fit their participant population. This new world of target date funds has resulted in the emergence of new trends.
Increased Variety of Offerings
The increased popularity of TDFs has encouraged investment managers and vendors to think about the next step. Now, managers are increasingly considering open architecture, incorporating the funds of competitors with unique capabilities that complement their own. This “unbundling” mirrors what has previously occurred in the core investment lineup of defined contribution plans over the past two decades. Managers are also evaluating passive versus active management, preferring passive management in efficient asset classes (e.g., large-cap core) and active management in asset classes with greater potential for generating alpha. Hybrid blend strategies, a combination of active and passive underlying strategies, have gained significant traction in the industry. The TDF series launched in 2018 from two of the biggest investment managers were both hybrid strategies.
Firms that manage TDFs have established additional target date series in an attempt to meet investors’ preferences. Initially, firms came to market with a single approach to target date investing but have since launched different versions of their TDFs; some with multiple glidepaths to address different levels of risk-tolerance. In general, there is a wide variety of glidepaths, ranging from very aggressive for investors focused on capital appreciation to very conservative for those focused on the preservation of capital. To illustrate this range, consider participants expected to retire in 2020. These individuals can select from equity exposure of up to 66%, or as little as 11%, depending on the target date fund manager (2).
Underlying target date investment managers are even exploring the inclusion of alternative investments and fixed income sectors with low interest rate sensitivity. These managers have swapped out some of the underlying active strategies with quantitative or smart beta strategies, in order to seek lower correlation among the actively managed funds. A select few managers are even using illiquid asset classes, such as direct real estate, in their target date funds. Others have incorporated funds based on environmental, social and governance (ESG) criteria. In today’s TDF landscape, off-the-shelf target date offerings have expanded to meet the variety of investors’ interests and needs.
Different Investment Structures
Not only do today’s target date fund providers offer variations of their strategies, they also make their strategies available in a different vehicle, via a collective investment trust (CIT). Since CITs are designed for qualified institutional investors, they typically cost less than mutual funds. Most of the recent launches of target date funds have been in a CIT structure, rather than in a mutual fund structure. It is important to note that these investment vehicles are not available in certain 403(b) plans.
Focus on Passive Management
One of the most significant recent trends for target date funds is the increasing preference for series that own passively managed funds. According to Morningstar, nearly 95% of the net flows to target date funds in 2017 went to TDF series that invest predominantly in index funds (3). This trend has narrowed the gap in assets under management between active and passive series. While active series still contain more assets, passive series accounted for 42% of target date assets in 2017, compared to 24% in 2008 (4). Fees for target date funds continued their multi-year downward trend in 2018. The injection of more passive exposure and the launch of TDFs that blend active and passive funds have contributed to this trend. In order to make their products more competitive, active managers have also lowered their fees.
2008 proved to be watershed moment for many target date funds. High equity exposure in “near-to retirement” date funds resulted in volatility and principal loss, forcing many participants to reassess their retirement date and income assumptions. As a result, managers have spent considerable time, effort, and money developing products and services designed to provide protection from similar market events and to meet participant desires for a steady stream of income through retirement.
In the development of these new products, asset managers, recordkeepers, consultants, and other third-party product and service providers are focusing on three key areas: (1) guaranteed income products developed to deliver a continuous stream of income in retirement, (2) asset allocation tools and services that utilize an employer’s underlying investment products to properly allocate a participant’s account and possibly provide a continuous stream of income in retirement and (3) custom portfolios allowing a plan sponsor to specify both the underlying investment options and the glidepath. Of the three, the asset allocation tools and services have had the highest usage and adoption rate by plan sponsors and participants.
Employers today have the ability to customize many aspects of their plans. This includes the core investment menu, plan design features, and even targeted participant communications. After an analysis of participant demographics and behavior, many plan sponsors have approached investment managers to develop customized glidepaths. Vendors and managers are developing methods to allow customization at the individual level as well. Today, the choice of target date funds is reflective of the participant’s desired retirement age. However, age may not be the only consideration. The next evolution of TDFs will likely allow the participant to customize the glidepath based on a variety of considerations, such as risk tolerance and total net worth. (Some plan sponsors offer a managed account solution to their participants, allowing for a more personalized approach to asset allocation.)
Plan sponsors and their participants are looking for ways to make their defined contribution plans look and feel more like defined benefit plans, and vendors are exploring ways to make this happen. While annuities have suffered from an image problem, retirees desire an income stream that can cover fixed costs. The next generation of products may incorporate an insurance guarantee around an investment portfolio. However, the adoption of these products has been modest at best, due to several factors, such as portability issues with a recordkeeper change and overall fees. It is expected that these issues will be addressed through additional regulation and product development.
Compared to the first generation of target date funds, recent TDF series are more diverse, less expensive, and often offer a combination of passive and active underlying strategies. They come in many varieties and forms and offer a great range in order to meet all types of investor needs.
The primary criticism of target date funds is that the glidepath is one-size-fits-all. However, investors who do not elect a TDF are more prone to attempt market-timing, a strategy that has consistently proven detrimental to their returns. Since target date funds allow investors to offload all investment decision-making to professionals, their appeal is likely to continue to increase. Therefore, additional innovation and development is expected to take place in the industry.
(1) Morningstar, “Target-Date Fund Landscape Report”
(2) Equity range based on TDF fund managers’ prospectuses
(3) Morningstar, “Target-Date Fund Landscape Report”
(4) Morningstar, “Target-Date Fund Landscape Report”
Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.
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