What did target date fund providers learn from the market crash a decade ago? Not much, for some providers, believes Richard Weiss, chief investment officer-multi-asset strategies at Kansas City-based American Century Investments.
The subsequent lengthy bull market has motivated some TDF providers to allocate more to equities, Weiss thinks. “The reason that some providers have done so well is that they’ve loaded up on equities, especially mega-cap U.S. tech stocks. Target date providers were getting pressure from clients and advisors: ‘Why aren’t you getting a higher return in this bull market?’” he says. “But the next time there is a big decline in the market, that is going to lead those providers to go off the cliff. It will be a wakeup call for some plan sponsors and participants on how risky an investment they’ve morphed into. Others will realize how risky their target date fund always has been, which they haven’t realized yet because they’ve only gotten in during the past 10 years, in the bull market.”
Not that the past decade has led target date providers to adopt cookie-cutter glide path philosophies and sub-asset class allocation approaches. “They are still created pretty differently across providers,” says Scott Donaldson, senior investment strategist at Valley Forge, Pennsylvania-based Vanguard Group. “There are differences in the level of aggressiveness of the glide path, from an equity standpoint. And within the glide path, there is a diverse set of strategies in how the providers have implemented it.”
‘Range’ Rovers?
Today’s target date funds typically have a relatively narrow range of equity allocations in the funds for investors early in their career, says Jeff Holt, Chicago-based director of multiasset and alternative strategies at Morningstar. “The allocations become more different as you get closer to the retirement date,” he adds. Glide paths more commonly go “through” retirement, he says, but the approaches at and in retirement differ substantially. “If you look at the extremes of equity allocations at retirement, the range exceeds 50 percentage points. One of John Hancock’s series has 8% in equity at retirement, and some providers have more than 60%. The industry average is 43%.”
How target date funds will do in the next extended market downturn depends on what they’re exposed to, Holt says. A decade ago, performance declines went beyond equities to numerous other asset classes. “In 2008, target date funds participated in the market volatility. The question is, will they continue to participate in the next downward market?” he says. “If the 2008 market environment were to happen again, the expectation is that target date funds will again participate in the losses. By and large, the main structure of target date funds hasn’t changed dramatically in the past 10 years.”
The Fidelity Freedom Funds have a slightly higher-than-average equity allocation early on (90% for the 2050 fund versus 88% for the industry average, according to year-end 2018 Morningstar data), then shift into a lower-than average equity allocation during retirement (24% for the 2005 fund versus a 33% average, Morningstar says). “From an overall objective standpoint, we’re trying to deliver something that helps participants maintain their standard of living in retirement,” says Sarah O’Toole, institutional portfolio manager at Boston-based Fidelity Investments. “For younger investors, we’re focused on achieving a total-return objective, and we’re sacrificing a bit of diversification to do that. Younger investors can better withstand downturns, because they have time to make it up,” she says. “Then, as people move closer to retirement and beyond retirement, our focus for participants is on providing diversification and resiliency across different market environments.”
The Principal LifeTime Funds’ allocation aligns closely with the industry averages early in the glide path, but then shifts into a lower-than-average equity allocation in retirement. (Principal’s Strategic Income Fund holds 23% in equity versus a 33% average for 2005 funds, according to Morningstar data.)A couple of main factors influence Principal’s design of its glide path, says Randy Welch, managing director and portfolio manager at Des Moines, Iowa-based Principal. It starts with doing Monte Carlo simulations to create an initial, optimally efficient allocation path. Then Principal has looked at participant data and behavior across its entire recordkeeping platform, to take into account actual utilization of TDFs.
‘Human’ Conditions
“We try to manage volatility by being realistic about participants,” Welch says, adding that those in TDFs tend to have lower balances than other participants. “If I just run Monte Carlo simulations unconstrained, it will say that I need to add more risk to the portfolio. But we’re also sensitive to the human side of this. Many individuals in target date funds who are approaching retirement are somewhat underfunded, but they are also concerned about volatility. Many of these people haven’t saved enough, but I don’t want to just increase the risk in the portfolio to try to make up for that.”
American Century’s OneChoice Target Date Portfolios have a glide path that’s “unique” and “flatter than most,” a Morningstar report says. Between the 2030 fund and the 2010 fund, for example, equity dips from 55% to 45%. “We’ve stuck with our original philosophy, and we’ve paid the price for it,” Weiss says. “We’ve lagged the performance of some of the more aggressive target date funds in the past several years. But we are sitting here with a process and a philosophy designed to work through a full market cycle, both a bull and bear market.”
“The reason for our flatter glide path is to minimize the ‘sequence of returns’ risk, meaning the risk of getting caught in an ’08 scenario right before you’re about to retire,” Weiss says. “It’s designed to smooth out returns over time.” He describes American Century’s TDFs as best suited for sponsors “concerned most about getting the highest proportion of their participants through to a successful retirement, not necessarily with the most money.”
‘Different’ Strokes
The Vanguard Target Retirement Funds maintain an equity glide path that matches up closely with industry averages throughout, Donaldson says. Vanguard seeks to balance risks that participants face equally, he says. “Investors in target date funds have many risks to contend with, and there are many different investment strategies to focus on certain risks,” he says. “We think that it is important to account for many types of risk. With a glide path design, you are making one selection for many people, who are in many types of situations.”
“If you talk to participants, you’ll find that they have different weights placed on different risks for each individual,” Donaldson continues. “Plan sponsors selecting a target date fund family need to put their fiduciary hat on, in the sense that they need to balance the different risks. You want the product that they believe might do the best for the most investors, and not one that focuses on one particular risk characteristic.”
The Retirement Series of T. Rowe Price’s target date funds has a higher-than-average percentage of equity around retirement: 55% for the 2020 fund, versus the 44% industry average that Morningstar cites. T. Rowe Price’s investment philosophy for the TDFs emphasizes longevity risk. “Our primary objective is supporting investors’ ability to have lifetime income, so that people do not run out of money,” says Joe Martel, a portfolio specialist at the Baltimore-based firm. “We also want to help overcome the reality that many participants are under-saving as a percentage of their income. The vast majority of participants save under the 15% general rule of thumb about how much people should save for retirement – and if they are saving 15%, it’s usually back-loaded during the later years of their career.”
Don’t Get Fooled
Target date funds still differ in how they seek diversification, Holt says. “The equity glide path just scratches the surface of the differences between TDFs,” he says. “The sub-asset class differences are still pretty prevalent. That’s where you see the differences in how much they allocate to investments like TIPS (Treasury Inflation-Protected Securities).”
Understanding target date funds requires going deeper than just knowing the equity versus fixed income breakdown, Weiss says. The glide path philosophy should filter down to the sub-asset class decisions and the individual stocks and bonds held, he says.
“In the target date fund world, the shorthand is to simply look at the glide path, which just shows the percentage of equities and the percentage of bonds, and which can easily be ‘gamed,’” Weiss says. “You can masquerade as a low-risk glide path by having a low equity exposure, but getting juiced up on exposure to things like commodities. It is critical to look at the next level of asset allocation, so you don’t get fooled.”
That’s especially important for understanding a target date fund family’s risks for those in or near retirement, says Weiss, who believes that protection against downside risks should dominate then. “It’s the diversification more than anything that matters at that point,” he says. “Concentrations are the enemy of a retiree.”
For Fidelity, its sub-asset class investment decisions revolve around increasing diversification, O’Toole says. “It’s a balance between growing the assets and protecting the assets,” she says. For example, in 2018 the Freedom Funds made allocations to TIPS and long-term Treasuries, to help with inflation risk. “We are focused on increasing diversification, given the uncertainty about the markets in the long term,” she says. “And inflation protection gets more important as investors age.”
Some target date funds have diversified more within fixed income the past few years. T. Rowe Price has added long-duration Treasury bonds and an absolute return fixed income strategy, for example. “While we believe that longevity risk should be the focus, that doesn’t mean we ignore volatility,” Martel says. “Our belief is that fixed income, and the level of diversification that a TDF has within fixed income, is by far the best way to address volatility. Because in the end, equities are equities.”
Vanguard now allocates 30% of its TDF fixed income portfolio to non-U.S. fixed income, Donaldson says. “Investment-grade, non-U.S. fixed income can be a pretty strong diversifier,” he says. “Having a combination of high-quality fixed income is important to reduce equity risk. The real value of fixed income in a target date portfolio is not return generation, but the volatility and risk mitigation.”
Market risk remains the greatest risk of a target date fund portfolio, whether a TDF allocates 80% or 20% to equity, Donaldson says. “Being broadly diversified across many different asset classes is one way to control downside risk,” he says. “One of the most common ways to do that is diversifying away from U.S. equities into non-U.S. equities, in both developed markets and emerging markets. It’s one of the few ways that you can diversify equity risk without moving out of equities.”
Vanguard has made several sub-asset class tweaks over the past decade, Donaldson says. “Most of those were in some way related to gradually increasing the global diversification of the funds,” he says, “moving more assets into non-U.S. equities and fixed income.”
In the spring of 2019, Fidelity increased the diversification of the Freedom Funds’ equity exposure, O’Toole says. “We moved from 70/30 in U.S. versus non-U.S. equities to a 60/40 allocation,” she says. “We want to preserve the home-country bias, because participants are funding U.S. dollar-based liabilities (their retirement-expense needs).”
International equity and fixed income holdings have increased among target date fund managers the past few years, Holt says. “Within the sub-asset classes, we’ve seen a move away from as pronounced a home-country bias,” he says. “Most of the TDFs are still weighted toward U.S. equities, but less so.”
Helping Sponsors Get Clarity
Sponsors need plan advisors to help them ensure they’ve matched the right target date fund family with their participant base and plan. “It’s about understanding the goals of the target date provider, and how that aligns with the goals of the participants and the sponsor,” O’Toole says.
To help sponsors decide, Welch suggests working with a plan’s provider to get TDF utilization data for a sample of the participant population. “They can look at the individual characteristics of those participants,” he says. “We look closely at the ‘belly’ of the age curve, from age 50 to normal retirement age. What sort of account balances do they have? What are their deferral rates at that point? If most of the participants have large account balances and are coming into their retirement funded adequately, the sponsor may want a target date fund that’s more conservative, because those participants have got plenty of assets. But other sponsors will want something more aggressive in that case.”
Utilizing the right target date family ultimately boils down to an employer’s philosophy, Martel believes, and he sees advisors playing a key role to help employers clarify that. “First, it’s helping them determine, what is their objective? Who are you trying to solve for: Is the employee population they’re focusing on those around retirement, or younger workers, or do they weight those populations evenly?” he says. “Then it’s looking at the different types of risks and outcomes: Do they want to put a greater emphasis on longevity risk, or do they want to limit volatility around retirement? Help them understand the tradeoffs.”
Sponsors need to understand the implications of prioritizing market risk or longevity risk, Martel says. “The cost of getting lower volatility will be lower balances at retirement,” he continues. “Some sponsors are willing to accept more volatility to increase the chances that their participants will retire with enough income in retirement. But it is perfectly reasonable to say, ‘I’ll take lower balances at retirement to have lower volatility.’”
Judy Ward is a freelancer specializing in writing about retirement plans. The article originally appeared in the Winter 2019 issue of NAPA Net the Magazine.
