Digging Deeper

Target-date funds (TDFs) were created in the early 1990s as a one-step solution for disengaged 401(k) participants—participants who failed to prudently allocate assets and wanted someone else “to do it for them.” While the theme was “set it and forget it,” however, the TDF strategy proved to be no silver bullet. During the 2008 market downturn, the concept showed inherent weaknesses, as many participants near retirement saw the value of their retirement investments drop nearly 40%.

While much of the blame is placed on asset allocations as determined by the TDF’s “glide path,” just as important­ in contributing to a fund’s success or failure are the underlying assumptions used to determine that glide path. These include assumptions about retirement age, longevity, savings rates, and capital markets.

Historically, the assumptions that go into creating the glide path have not gotten much scrutiny from advisers, says Ron Surz, Founder of Target Date Solutions. The big-three bundled service providers, T. Rowe Price, Fidelity, and Vanguard, were early providers of target-date funds, offering their proprietary funds on their platforms—sometimes only allowing their proprietary funds to be used—meaning plan sponsors and advisers generally did not review the underlying assumptions or risks of the funds, says Surz. Many plan sponsors who put these funds in their plans have kept them, leaving those major players with a dominant position in the target-date funds market. Even after the recent market downturn, most advisers still are not vetting underlying TDF assumptions, so decisions often are made without fiduciary due diligence, he says.

Part of the reason why those assumptions have not been reviewed, says Surz, is that TDF providers have historically not disclosed underlying assumptions. When asked to disclose these assumptions at recent Department of Labor hearings, he says, the fund providers were unwilling to do so.

However, the 2008-2009 market downturn revealed that TDFs carry more risk than many realized. Advisers, therefore, should be vetting TDFs on their clients’ behalf, says Surz. To do this, advisers have to understand the inherent assumptions of any TDF fund family they recommend to clients.

One of the most basic, core assumptions that all advisers should review prior to recommending any TDF is the actual time period the glide path is designed to cover. “Different target-date fund providers have different assumptions as to what they are designed to do,” says Tom Fontaine, the Head of Defined Contribution Business for AllianceBernstein. Some providers, he says, design funds on the theory that all the money is moved out of the plan at retirement. This strategy is sometimes referred to as the “to” retirement approach, in which the glide path is designed to end, or become static, at retirement.

The majority of TDF products, however, are designed with the assumption that the participant is invested in the product until death, says Don Stone of Plan Sponsor Advisors in Chicago. The fund providers assume that, on termination of employment, the money is rolled over into an IRA in the same investments (or left in the plan) and withdrawn slowly through retirement. For example, he says, Fidelity Freedom Funds are designed for death at age 87, so the glide path still has a relatively high equity exposure at age 65. This is referred to as the “through” retirement approach. Fidelity, along with T. Rowe Price and Vanguard, which account for roughly 75% of the TDF market share, all base their TDF assumptions on asset retention through retirement.

While the “through” retirement glide path strategy dominates the industry, some believe that it is inappropriate for the majority of participants. “Target-date funds are supposed to be target-date funds, not ‘target-retirement funds,’” says Surz. The reality, agrees Stone, is that most participants actually roll the money out within three years after termination of employment into other investments.

Beyond typical participant behavior, some question if keeping funds in TDFs through retirement is wise. “Target-date funds,” says Stone, “really are not efficient at creating income.” The only way to get income in retirement, he points out, is selling off principal. “It’s not a strategy designed to generate income other than by selling off assets,” he says.

Another thing advisers should be aware of is the provider’s propensity to shift glide paths, broadly described as the fund’s shifts between asset classes over time. It’s not unusual for glide paths to shift over time, certainly from what might have been depicted when the fund was originally chosen, says Kevin O’Connor, Senior Product Manager for Russell Investments’ U.S. Advisor-Sold Business. When trying to evaluate a TDF’s glide path, the glide path is depicted as stable, but the reality is that glide paths and their asset allocations can change substantially over time, says Thomas Idzorek, Global Chief Investment Officer for Morningstar Investment Management. Therefore, he says, advisers and plan sponsors may not be getting an accurate depiction of what the glide path actually will look like over time.

It is relatively common for those glide paths not to remain static over time, particularly when there has been manager turnover, explains Idzorek. Fidelity Freedom Funds’ glide paths have jumped around through the years because different managers have put their own spin on the glide path, he says. T. Rowe Price’s glide paths, by contrast, have been fairly consistent, he adds.

Sometimes glide paths are revised due to market conditions. After 2008, many TDF companies revised their glide paths to become more conservatively invested as participants approached retirement, notes O’Connor. Russell, he says, was already conservatively invested, so it did not need to do this.

The Mystery Components 

The assumptions underlying glide path construction revolve around there being a “typical” participant investing in the fund, says O’Connor. For example, he says, Russell’s non-customized TDF solutions assume that all participants start investing into the fund at age 25 and continue investing until age 65. Russell TDFs also assume that all participants are saving at a rate of 6% of income, adjusted over time for inflation and wage increases.

The actual assumptions used to re-create the “typical” participant vary from provider to provider. However, generally what the industry claims is used in generating glide paths, says Surz, are typical participant savings and spending in retirement. Savings for the typical participant include: current accrued savings; other sources of retirement income; desired pay replacement at retirement; current pay and projected pay increases; and savings patterns through time. Spending in retirement includes: spending discipline; other assets, including Social Security; life expectancy; and life events, such as medical costs.

Capital Market Assumptions

The problem is, of course, that, at best, says Surz, any given TDF only really applies to the “average” participant. That “typical” investor envisioned by standard, off-the-shelf TDF products often rarely exists. If someone is not saving over the full 40-year term envisioned, it could significantly impact wealth in retirement, admits O’Connor, as can someone not saving enough. If the assumptions are not met, then one outcome can be that participants have far less to meet their retirement needs, he says. However, it can go both ways. The more reality deviates from the core assumptions, the more the actual outcomes, positive or negative, can deviate, he says.

Yet, despite the flaws, says O’Connor, an off–the-shelf TDF product can still produce a better outcome for disengaged participants. The glide path is a huge improvement for disengaged investors, he says, but it is still not perfect, so the industry is already working on next-generation solutions (see “DIY Funds,” page 40).

TDFs are a relatively young product, and their performance in that short period of time has been questionable.

DIY Funds

If a client is large enough, it may want to consider forgoing off-the-shelf TDF products and having a family of TDFs designed specifically to meet its participant demographics. Large plans now often use custom glide paths to meet the specific demographics of their participants, says Kevin O’Connor, Senior Product Manager for Russell Investments’ U.S. Advisor-Sold Business.

AllianceBernstein is seeing a strong and growing interest in custom funds and advisers’ interest in selecting custom solutions, says Tom Fontaine, the Head of Defined Contribution Business for AllianceBernstein. At AllianceBernstein, the majority of TDF accounts are custom, says Fontaine. Companies create a glide path using underlying assumptions that meet their specific demographics. Generally, plans need at least $50 million to $100 million in TDF accounts for a customized option to be affordable, he says.

There are many advantages to customized TDFs. The assumptions in a TDF can become much cleaner in a customized option because you are looking at the demographics of a specific plan, says Fontaine. For example, he says, if the employer also sponsors a defined benefit plan, then the defined contribution plan is supplemental, and that might allow more risk for those participants. If there is no defined benefit plan, he says, but the match is in employer stock, the TDF should then probably be more conservative. Things such as overall compensation and savings rate, and employee turnover also can be factored into a customized option. If there is high employee turnover, a more conservative investment strategy may be appropriate, he says. —ERD

What TDF Assumptions Mean for Plan Sponsors

Not vetting TDFs and adequately explaining the potential consequences of those assumptions to both the plan sponsor and participants can lead to problems down the line. The glide path strategy and capital market assumptions, in particular, can affect TDF outcomes significantly, says Kevin O’Connor, Senior Product Manager for Russell Investments’ U.S. Advisor-Sold Business. Additionally, notes Ron Surz, Founder of Target Date Solutions, if a TDF assumes participants are not saving enough for retirement, it may invest more heavily in equities, increasing market risk if there is a market downturn.

When recommending TDFs, advisers should match a particular set of funds to a particular client’s demographics, says Philip Steele, Chief Executive Officer of Pension Architects in Malibu, California, which builds customized target-date funds for clients. Too often, he says, advisers get comfortable with a particular set of TDFs and recommend it to all clients.

Advisers need to look beyond performance to whether or not the assumptions and glide path make it appropriate for a specific plan’s participants, says Don Stone of Plan Sponsor Advisors in Chicago. “You want to do what’s in the best interest of most participants in the plan,” says Tom Fontaine, Head of Defined Contribution Business for AllianceBernstein.

In addition to reviewing TDFs for clients prior to going into a fund, if a plan is using a bundled approach and currently offering only the vendor’s TDF funds, says Stone, advisers and plan sponsors should go back and do the due diligence to ensure that those funds are appropriate for plan participants. The due diligence should be done even if the funds are the only option for TDFs on the platform, he adds. At the very least, says Surz, advisers should understand the amount of risk at the target date and explain that risk to the plan sponsor and to participants.

TDFs are asset-allocated strategies, points out Fontaine, so fiduciaries need to consider whether the glide path is appropriate for a plan’s participants as well as look at the underlying fund components to make sure it is an appropriate investment for that plan.

Among other things, says Stone, advisers should be looking at participant behavior at or near retirement and see whether the fund’s glide path is an appropriate fit. Advisers should ask whether participants generally roll over into the same assets at retirement and withdraw slowly, or roll over into new investments immediately, says Fontaine.

Advisers also need to understand the assumptions the TDF uses for participants and compare that with the actual demographics of the client plan to make sure there is a match, he says. “You may never get a perfect fit,” Fontaine says, “but the reasonableness of the embedded assumptions in the overall glide path should be considered.”

Review retirement age assumptions­, says Stone, and compare that with the plan’s actual experience. If the TDF assumes that all participants retire at age 65, and the plan’s participants generally retire at age 55, then the equity allocation at 55 may not be appropriate for that plan’s participants. Stone also believes that advisers should ask how the TDF is designed to provide for distribution.

Additionally, when evaluating a TDF product, advisers should make sure there is adequate transparency in the product and ask how the product protects participants in a down-market cycle, says Bill Carey, President of Retirement Services for F-Squared Investments. Among the things advisers should consider are risk, management tenure, management style, expense, and the way the TDF migrates over time, says Steele. —ERD