As more plans adopt qualified default investment alternatives for their set-it-and-forget-it participants, target-date funds have grown to nearly $2 trillion in assets. Now that the problem of getting people enrolled in a retirement plan has been addressed, it is time to tackle how investments in these plans are chosen to make sure there is a focus on long-term outcomes and performance.
The Georgetown University Center for Retirement Initiatives and Willis Towers Watson conducted a study of target-date funds to find out how participants who are able to save for retirement are investing their money — and if they are getting the best bang for their buck for every dollar invested, says Angela Antonelli, executive director of the Georgetown University Center for Retirement Initiatives.
The Center for Retirement Initiatives wanted to find out whether increased asset diversification, including alternative asset classes such as hedge funds, private equity and real estate, would improve retirement income in the long-term. It found that diversification gives between a 7% to 11% boost in retirement income over the long term and ensures that a participant’s dollars last a longer period of time in retirement.
In its model, the Center found that a “diversified TDF increases the amount of annual retirement income that can be generated by converting a participant’s DC balance into a stream of income at retirement by 17% or $9,200 for every $100,000 of pre-retirement annual wages in the expected case or by 11% or $2,300 in annual retirement income in a worst-case or downside outcome scenario.”
Jason Shapiro, senior DC strategy consultant for Willis Towers Watson, says that his company acknowledges that “there’s been significant improvement in plan design, technology and communications, getting people into plans and to save more. It has had a significant impact on people’s ability to accumulate in DC. Where evolution is further needed is building out that investment portfolio to access the same return drivers used in defined benefit plans, endowments and foundations.”
By building alternative asset classes into the target-date construct those more complicated assets are managed by a professional manager, which means that participants can benefit from the diversification of their assets without an additional layer of complexity.
Ron Surz, president of Target Date Solutions, has been a huge proponent of diversification in target-date funds since he first entered the market in 2006. He points out that the three largest providers of TDFs, Vanguard, Fidelity and T. Rowe Price, are not very diversified. In fact, the bulk of their assets are held in U.S. large cap stocks.
He believes plan fiduciaries, especially advisers, are opening themselves up to risk by not doing a better job of vetting the assets included in the TDFs they include in their workplace-sponsored retirement plans. He also agrees that TDFs should include alternative investments.
Off-the-shelf target-date funds don’t do a good job of targeting specific employee demographics. And although plan sponsors and advisers are very aware of the fees being charged now because of litigation, many don’t know what they are really getting with the off-the-shelf TDFs available today.
He encourages employers to take a more active role in how their target-date funds are constructed. If they don’t, he believes they could open themselves up to litigation in the future.
Shapiro says that the 401(k) industry is wary of adopting custom target-date funds because they don’t want to be sued for breach of fiduciary duty for their selection of investment options.
“What we underscore is that many issues that come up in that context can be easily addressed and are being easily addressed in the use of custom funds,” he says.
He adds that employer plans are being “more cautious than they need to be based on real experience. Our analysis underscores that.”
Plan sponsors have the ability to incorporate alternative asset classes in their target-date funds now, Antonelli says. She hopes that the Center’s research will encourage policymakers to provide additional guidance to help alleviate the concerns that plan sponsors have about whether or not they are at risk with respect to fiduciary obligations if they include alternative investments.
“That would be helpful in terms of encouraging further adoption of custom funds and inclusion of alternative assets,” she says.
Shapiro says that even if a plan sponsor chooses an off-the-shelf TDF, and someone else is responsible for the glide path development and construction of the underlying portfolios, the plan sponsor is still responsible for the oversight of all those pieces. They still need to do their due diligence.
Surz agrees, saying that employers have a “duty of care. They need to try to find the best, and as great as those three are, there are much more target-date funds on the market.”
During the financial downturn in 2008, target-date funds run by the big three providers lost 25% of their assets. Back then, there was only about $200 billion in assets held in target-date funds. Now it is close to $2 trillion. Between 40% and 50% of these company’s TDF offerings are in equities.
“The magnitude of the problem is huge. Fund companies are expecting a performance horse race and they are expecting equities to win in the long run,” he says.
He believes that plan fiduciaries have developed the wrong mindset which has led to bad decisions. The first one is that any qualified default investment alternative will do. That’s not true, he says. The safe harbor requires that “advisers at least try to find the best.”
Auto-enrollment, auto-escalation, participant investment advice and Roth 401(k) availability are among the important traits of a plan.
When the first lawsuit hits after the next market downturn, he believes that plan fiduciaries will have to have documentation showing how they chose the product they did, including whether they interviewed different fund managers. It is also important for them to have an investment policy statement for their funds.
Advisers may feel pressure to pick a TDF from one of the big three TDF providers but “popularity is not synonymous with prudence,” he says. “The big three are fine companies but there are some good target-dates out there that are not getting the business that they should.”
Employers need to keep in mind the demographics of the employees who default into the plan. Those are the target market for target-date funds. These are individuals who don’t have a clue what they are doing and it is up to the employer and adviser to help them make the right decisions. Surz believes that plans don’t have to adopt a custom TDF to be safe. They just need to be prudent in their selections.
He believes that many off-the-shelf target-date funds take too much risk at the target date, pointing out that the big three invest between 55% and 60% in equities that late in the game. He believes that funds should include 10% broadly diversified equities at the target date.
He then believes that funds should re-risk to 45% equities by age 85 and level off after that.
“The reason for that is when you first begin your retirement years, if you are one of the unfortunates to lose those savings, you will have to curtail your standard of living and you might outlive your money,” Surz says. “As you get older, the safe assets won’t serve you that well. You will need to get more from the capital markets. That’s where re-risking comes into play.”
