by Steve Goodman
CPA, MBA – President & Chief Executive Officer
Contact Steve today for more info.
Target Date funds (TDF’s) are retirement vehicles designed to gradually reduce the amount of equity exposure in the portfolio as retirement approaches. These funds have become very popular in company 401(k) programs. 90% of all 401(k) programs have a target date fund option. As of 2015, 23% of all 401(k) assets were invested in these funds. A Vanguard analysis concluded that 40% of all participants in defined contribution plans solely invested in TDF’s in their workplace accounts.
Part of the reason for target date popularity in 401(k) programs is the Pension Protection Act of 2006. This law encouraged companies to auto-enroll new employees in their 401(k) programs and use a default investment alternative if the employee does not select one or more funds. The law recognized TDF’s as acceptable default investment alternatives.
Perhaps not unsurprisingly, many investors in TDF’s have only a basic understanding of how TDF’s work and potential problems with investing in TDF’s. A Voya Investment Management survey found that 46% of TDF investors listed diversification as the reason they also invested in other funds. A Financial Engines study found that 62% of investors who partially allocated their savings funds to TDF’s used other funds for diversification. Most recognized that the TDF’s were already diversified. Yet they were uncomfortable putting all their funds in a single investment.
How TDF’s Work
Target Date Funds are identified by multiple characteristics:
- They may be a fund of funds (most common) or funds themselves.
- They may be actively managed or passively managed
- They may employ an investment philosophy of ‘to’ a retirement date or ‘through’ a retirement date.(see following section for definitions of ‘To’ and ‘Through’)
- They employ proprietary glide paths that may be very different from one company to another.
Fund of Funds – Most TDF’s are offered by fund families. The five largest TDF companies are Vanguard, Fidelity, T. Rowe Price, American Funds, and JPMorgan.These firms offer a wide range of mutual funds. The typical fund of funds TDF holds 17 funds. The same fund family will offer the overwhelming majority of these funds. This raises a potential red flag as to whether investors are getting the best funds available.
Active vs. Passive Management – TDF’s may be actively or passively managed. TDF’s that are not fund of funds are almost certainly actively managed. It is difficult to justify spending money to establish a passively managed TDF that does not own other funds.
The difference in actively managed vs. passively managed funds makes a difference in two areas. The first is the fees. Passive management costs a fraction of active management. Passive management requires no investment analysis, no risk/reward determinations, and no need to evaluate products or markets. Passive management involves duplicating the performance of an index over good markets, bad markets, and sideways markets. It is a statistical process that computers are quite capable of handling. Passive fees are generally minimal.
Actively managed funds rely on analysts to assist in selecting investments with better than average prospects in their categories. The analysts often travel to see companies, attend conferences, tour plants, and meet with company management. Care and feeding of analysts and fund managers can be expensive. Fees on active accounts can be 5 to 20 times the cost of a passively managed fund. If the actively managed accounts indicate a history of generating returns in excess of the passively managed accounts for the same level of risk, then it is worth paying for the extra fees. This is often not the case, though these things tend to run in cycles.
TDF’s, especially fund of fund TDF’s, will require investors to pay two levels of fees. The first is for the portfolios/funds they buy. A TDF that owns 17 funds will pay management fees for all 17 funds. Additionally, the TDF will charge a fee for managing the fund of funds.
‘To’ vs ‘Through’ – A ‘To’ TDF is designed with the expectation that the investor will withdraw some or all of his/her money from the fund upon achieving the retirement age. To funds represent a minority of TDF’s. Many of those that exist assume people will roll some or all the retirement funds into an annuity upon retirement. Some company-sponsored plans have annuity rollovers as a built-in option.
Through funds are a much larger portion of the existing TDF’s. Four of the largest plan series by asset value from Vanguard, Fidelity, T. Rowe Price, and American Funds are Through funds containing 73% of all TDF assets. These funds are intended to be held by people through retirement age and beyond. Unlike To funds, these funds make provisions for the risk they believe an 80-year-old woman should take in the event she lives an expected lifespan based on reaching 80. They are designed to be held for life.
Glide Paths – A glide path is an annual allocation that a TDF will employ as it reduces risk as the investor gets older. The glide path concept assumes that bonds are less risky than stocks and that cash is less risky than bonds. As one age, one has less time to recover from a string of poorly performing investments. To minimize the effects of a poor market just as a person is about to retire, the glide path reduces but does not eliminate, equity allocations as people approach retirement.
All TDF’s employ glide paths. They are listed in the fund prospectus. They are available online and virtually all of them can justify why they appear as they do. Yet when one compares the glide paths of many different companies offering a similarly dated TDF, the paths can be very different. Each is modeled based on unique assumptions leading to unique glide paths. A Morningstar study looked at many 2020 dated TDF’s. With 5 years until retirement, the average equity exposure was 40%, with a high of 60% and a low of 15%.
Every TDF prospectus includes a glide path. One must read the prospectus to learn whether the glide path is a rule or a guide. Many prospectuses allow portfolio managers to deviate from the glide path by a certain amount to take advantage of market opportunities. Those invested in passive funds will have no reason to deviate from the glide path. Those under active management are much more likely to use this freedom.
Results of TDF’s
As retirement investment vehicles, TDF’s have performed well in some areas, but not all. A 2016 study by the Center for Retirement Research at Boston College looked at TDF results. They concluded that TDF’s performed about as well as the typical mutual fund. Due to fees, both the typical fund and the typical TDF underperformed the market by roughly 70 basis points each year.
As asset allocation vehicles, the evidence is less positive. People invested in 2010 target date funds were clobbered by the Great Recession of 2008-2009. Equity portfolio percentages were set too high in hindsight. Many retirement portfolios were severely impacted by the market crash at a time when investors had just a year or two until retirement.
The reasons for the high equity proportions include the higher fees charged on equity investments as compared to debt and cash investments. While the Great Recession and similar crashes are not common, a quick review of market history indicates that 20+% declines occur with some frequency.
The study also conducted research to identify the benefits of giving portfolio managers the freedom to deviate from the glide path. Presumably, the managers would use this freedom to take advantage of unique timing opportunities. The study found that the average annual return contribution for this freedom was -11.5 basis points a year. If weighted towards funds with longer track records, the return was even worse at -14.1 basis points. Active management using flexibility produced losses. Those employing passive management with no flexibility showed better returns.
The study found that fund managers tend to make investments that help the fund family sometimes to the detriment of the investors. The results showed three fund favoring behaviors that worked to the detriment of investors.
- TDF managers favor start-up funds within the fund family. Start-up funds tend to show lower returns than mature funds.
- TDF managers favored higher fee funds. These funds showed lower performance than alternative funds, though not a statistically significant difference.
- TDF managers showed a preference for smaller funds. The assets from the TDF’s bolstered the assets under management to help grow these smaller funds. Smaller funds statistically perform worse than larger funds.
Alternatives and Recommendations
The primary reasons to use a TDF are diversification and asset allocation. Investors who feel uncomfortable investing all their assets in a single fund typically fail to consider the asset allocation of their portfolio as a whole. By investing in other funds, they overweight stocks or bonds in their portfolio considered in its entirety.
Asset allocation is a key determinant of portfolio value, especially as one approaches retirement. It is possible for an investor to design a custom glide path. The investor can even copy a glide path from a prospectus. The challenge is to have the discipline to administer annual asset allocations, regardless of market conditions. TDF’s make asset allocation relatively easy and inexpensive. Most 401(k) plans offer a limited number of fund choices. There may be only one TDF family from which to choose. Those in a self-directed IRA will find over a thousand TDF’s.
Robo-advisors are a new concept in money management. These computerized advisory services are emotionless. They do not recognize ‘unique opportunities’ worthy of glide path deviations. Someday, robo-advisors will benefit from artificial intelligence. As of 2018, they are relatively new and untested, especially in down markets. The day may come when robo-advisors can identify the optimal strategy for target date funds. But that time has yet to arrive. When it comes to asset allocation, people have three choices for the near term:
- Do It Yourself
- Pay a financial advisor to implement an agreed upon glide path over a period of many decades
- Invest in one or more TDF’s if investment fund diversification is a concern.
If the 3rd option is your choice, look at fees, look at performance, and look at the glide path. Are you comfortable with the risk presented? If you are comfortable with the fees and the performance, you can adjust the glide path to your liking by buying a later dated fund (it will have more equity) or an earlier dated fund (less equity).
CPA, MBA – President & Chief Executive Officer
About Steve Goodman
For more than 30 years, Steven has provided insightful solutions to the challenges of business succession, wealth preservation and charitable planning, focusing on the needs of owners of closely held businesses and high net worth individuals.
He's been featured in the New York Times and is an accomplished speaker and has presented over the years to many organizations and professional groups on efficient business succession, estate planning issues and tax strategies. Steven is a CPA who was vice president of the Trust and Investment Division of JP Morgan Chase and a supervisor for KPMG Peat Marwick, and holds an MBA from Fordham University.