Elements of Target Date Funds
A few months ago, we started a conversation about the increasing popularity of Target Date Funds (TDFs) and, therefore, the increased duty plan sponsors had towards vetting these investments. In our December 2013 newsletter, we started to describe some of the differences between traditional investment manager due diligence and TDF due diligence. We would like to continue this conversation and describe the features of Target Date Funds more fully so that investors –both individuals taking care of their own retirement and employers scrutinizing their retirement plan lineup – can make more informed decisions.
The Glide Path
One unique attribute of a target date fund series is its “glide path”. As a target date approaches, the funds within a target-date series allocate more underlying assets towards fixed income and cash and away from equities. In other words, a 2050 TDF within a series would have a high percentage of equity while a 2020 TDF would have substantially more fixed income. The obvious questions include, how much equity does a fund series start with? How many bonds does the series end with? Does the transition from equity to fixed income happen in a linear way or are there periods of greater change, and why? To answer these questions, most target date funds provide a literal graph which details the amount of equity at the beginning of a target date fund series, the amount of equity at the end of the series, and how that transition occurs over the years. That graph is the glide path.
Glide Path differences
Compare any two target date series’ glide paths and you’ll see a basic downward slope shape; as time goes down, the percentage of equities goes down. However, you’ll begin to notice which series’ are more aggressive - with high proportions of equities at any given target date – and which are relatively defensive.
While the glide path reflects the current allocation of equities and fixed income between the funds within a target date series, that path can change over time. For example, an active money manager might allow a 2060 target date fund series to be 100% equity or as little as 80% equity depending on the valuation metrics of the stock market. Rather than a set line – a clear path – this fund series has great flexibility to change the path to suit market conditions. This manager is using a “glide range” instead of a glide path.
The latitude given to the portfolio manager responsible for determining overall weights of equity and fixed income may also extend towards the allocations within those broad asset classes. For instance, a portfolio manager may find US large growth equities particularly favorable and chose to overweight that “sleeve” within the target date fund series. The decision process for each target date series may reflect tactical flexibility to changing market conditions or a well-defined strategic discipline. Investors should understand what triggers a rebalance in the allocation in a target date fund. Is it simply a function of time? Or is the portfolio manager allowed to over-weight and under-weight individual sleeves within the portfolio based upon their analysis of current market conditions?
To-Retirement or Through-Retirement
Another frequently used attribute for distinguishing a target date fund series: the last point of change. For example, imagine you are an investor who planned to retire in 2010, so you purchased shares in a 2010-vintage retirement fund. It is currently 2014 and you still own those target date fund shares. You might have expected the underlying allocation of fixed income and stocks to have stayed the same for the past 4 years since 2010, but you are surprised to learn that the proportion of fixed income and equity within those shares have changed and they will continue to change for another decade – all the way to 2025.
Funds that continue to shift the proportion of equities and fixed income after the named target date are considered “Through-Retirement” funds. Alternatively, “To-Retirement” funds have a stable asset allocation once investors reach the named target date.
The reason for multiple types of target date fund types is because investment managers have been tasked with solving different problems. The different goals of an investment manager will determine the structure of the target date fund series. For example, investment manager A’s mandate may be to protect individuals from the loss of purchasing power from inflation. Investment manager A is worried about longevity-risk of retirees and will likely end up with a Through-Retirement fund which contains more assets with the potential to exceed inflation over time. Investment manager B also creates a through-retirement fund, but with more modest goals. Investment manager B created a model of investor behavior and tried to design a fund which provides a modest income replacement of 60% of a retiree’s income during retirement. Alternatively, investment manager C is primarily concerned with managing volatility and risk-budgeting, and he may establish a more defensive To-Retirement fund series. Investment Manager C’s To-Retirement fund series is extremely sensitive to market risk – even providing insurance against market crashes with “puts” and other derivatives – and embraces a low and stable allocation to equities at the retirement date.
To make matters more complex, large and respected investment management firms can look at similar data and come to different conclusions. Many funds create models of historical participant behavior and use that analysis to guide the decisions around fund makeup. Manager A notes that the majority of retirees, once they leave the workforce, are likely to cash-out of an workplace 401(k) plan and roll over these assets into a separate IRA. Therefore, their target date solution is To-Retirement, to increase transparency in policy and portability. Conversely, manager B has also considered participant behavior, but they have noticed employees are not saving enough for a long retirement. Manager B worries that To-Retirement series are too conservative, given American workers’ lack of retirement preparation. Therefore, manager B’s target date series is Through-Retirement.
Underlying Investment Managers
Now that we’ve discussed the overall allocation of equities and fixed income, let us go one level deeper and look at the structure of the investments within a target date product. For simplicity target date funds are usually set up as a fund-of-funds. In other words, your 2025 target date fund might be the combination of several existing funds. How are the underlying funds – the separate investment management sleeves – chosen?
Global investment bank ABC owns a variety of investment management boutiques and proprietary investment management products. It may be in their best interest to create a target date fund solution made of their own products. On the other hand, competing bank XYZ might recognize that ABC investment bank’s selection of underlying investment managers is biased. XYZ might try to create a better target date solution by selecting the best investments they can – whether they are associated with XYZ or not – and then try to sell their best-of-breed approach to investors.
Both approaches - in-house and outsourced management - are popular. In-house management selection, favored by ABC, is often less expensive since the investment bank gets the economy of scale. ABC bank can share revenues between the underlying investment managers and the top-level portfolio construction and oversight team. Furthermore, using an independent, outsourced set of investment managers that do not coordinate with each other can create inefficiencies. Specifically, using uncoordinated outsourced managers can offset the active bets within a portfolio. For example, imagine a retirement date fund with a large cap growth manager and a large cap core manager. The underlying large cap growth manager is buying IBM stock. At the same time, the underlying large cap core manager is selling IBM stock. These two trades offset each other and create clear inefficiencies. If a multi-manager portfolio has significant offsetting active bets, it means that investors are paying for unnecessarily paying for trading fees for both the buyer and the seller; transactions are not free. Furthermore, investors are paying active management fees and are likely to get passive, index-like performance instead.
On the other hand, outsourced management selection favored by XYZ often benefits from diversity of opinion; a single management structure, such as ABC’s, can lead to “group-think”, where the underlying investment process is similar between various products using the same in-house analysis. Furthermore, XYZ is more flexible and unbiased; they don’t have to pretend that their in-house investment managers are automatically the best choice for each and every investment sleeve. They have the ability to use any manager they feel has the best opportunity to succeed.
Alternative Fund Structures of Investment Products
Up until now, the investments we’ve been discussing have shared the same structure: a traditional open-end mutual fund made of other mutual funds. It is worth mentioning that there are alternative structures for target date funds. For instance, rather than combining several funds together, some target date products are based upon a diversified, individually managed fund. This diversified fund exists specifically for a target date product. This diversified single fund avoids the problem of offsetting active bets we referred to earlier.
Another common structure for target date products are not funds, but rather Collective Investment Trusts (CITs). Collective trusts are co-mingled investment pools – like mutual funds – but they are often specific to individual recordkeepers, banks or trust companies. Collective trusts are only available to ERISA qualified plans (individuals and government plans cannot use them). The key advantage for a CIT is that it is often less expensive than a comparable mutual fund. The key disadvantage is that CITs are harder to compare against peers - a necessity for determining prudence. Also, CITs are often bundled into recordkeeping and custodial relationships, making them less portable for investors.
Exposure of underlying investments
We’ve discussed the overall allocation of equities and fixed income, and underlying investment managers, but it’s worth going down yet one more level to look at the investments themselves. As we noted in our December 2013 newsletter (Evaluating Target Date Funds – Part 1), these funds are supposed to be comprehensive, optimized, single-stop investment solutions for investors. As “optimal” solutions, you might think that the results would be similar between different fund families; after all, a solution to a math problem is the same, no matter who is solving it.
In reality, investment managers sometimes cannot even agree with themselves on arriving at a single, ideal solution. For example, some large investment managers offer multiple target date fund series: one made of low cost passive-indices, and one made from active managers.
Given that such differences in approach can exist even within the same company, it should come as no surprise that there are significant differences between competing investment managers. Notably, the investment exposures are not shared among competing investment managers. Most managers can be expected to use broad US equity exposure, across the growth and value spectrum and healthy exposure of large and small companies. On the other hand, not every manager will be equally inclusive of international equities; some won’t have any emerging market exposure at all. Furthermore, fixed income exposure is surprisingly irregular, with intermittent exposures to high yields, international bonds, and specialty fixed income like TIPS or convertibles. Alternative investments are even rarer within target date funds. Competing target date solutions will have dissimilar approaches to alternatives (such as commodities, real estate, or absolute-return strategies).
Practical considerations for selecting your Target Date Fund solution
Given the complexity of the target date funds space and the existence of dozens of completely rational, but disparate approaches to target date solutions, how do you know which solution is best? At this point, a retirement plan sponsor should seek clarity from understanding the needs of their employees. Understand your participant demographics and how that affects Target Date solution. What other choices – like a pension or ESOP – exist for employees? What is a typical salary range? How long do employees stay with the company? How do they interact with the plan? Are they contributing to their retirement at a healthy rate? These considerations will help determine what features of a target date solution would be most useful to your employees. Your consultant can help you determine which series might be the best fit for your employees.
Sources & Other Reading
US Department of Labor – Target Date Retirement Funds – Tips for ERISA plan fiduciaries
Plansponsor - Rules / Regulations: Hitting the Target
Morningstar Target Date Series Research Paper
Determining the Most Appropriate Target Date Fund for a Qualified Default Investment Alternative
Rethinking TDFs as QDIAs: Why Target Date Funds are a Fiduciary Nightmare for Qualified Plans