TDF Evolution

Art by Meg Hunt

Every product introduced goes through a time of development and improvement—consider the evolution of computers and cell phones. The same is true with target-date funds (TDFs).

According to Chip Castille, BlackRock chief retirement strategist, based in New York City, the first TDFs were a new category of investment vehicle. At the time they were introduced, in 1993 by a BlackRock acquisition, defined contribution (DC) plans were only about 13 years old. Target-date funds were an innovation meant to help manage asset-allocation risk through time, but the types of assets in which the funds could invest were restricted by the availability of asset classes that worked within mutual funds or collective investment vehicles.

Over time, TDFs have gathered increasing amounts of DC plan assets, and now there are a greater number of classes from which to choose.

Castille says BlackRock has a full-time research group evaluating TDFs to understand the needs of participants and what asset classes are available. Over the years, this has resulted in changing the risk profile of the BlackRock target-date fund’s glide paths. “In 1993, we had a landing point of 20% to equities. Now it’s 38% to 40%. We’ve expanded asset classes into Treasury inflation protected securities [TIPS] and commodities, and, on the active side, we’ve gone from quant only to more fundamental asset management. It’s a constant evolution,” he says.

Some recent additions to the target-date fund market highlight examples of the ways in which investment managers are evolving their thinking.

Addressing Market Volatility
This year, Beaumont Capital Management, a provider of quantitative exchange-traded fund (ETF)-based investment strategies, launched an alternative to TDFs in the form of risk-managed collective trust funds.

Beaumont says the new product approach “addresses the need for a more versatile investment solution that seeks to benefit in growing markets and can react appropriately and decisively in periods of market volatility.” In addition, according to Beaumont, the products are “designed to address the current Department of Labor [DOL] and industry concerns with other target-date funds.”

Dave Haviland, managing partner and portfolio manager of Beaumont Capital Management in Needham, Massachusetts, explains, “It’s not necessarily that we think there were problems with previous iterations of target-date funds, but the DOL, Securities and Exchange Commission [SEC] and the industry identified the cost of defined contribution investments as a great concern, and there has been a tremendous amount of effort to lower costs. We believe we are the lowest-cost TDFs with active fund managers in the market.”

In addition, Haviland notes, target-date funds currently are being managed with little to no defense against market volatility. “If you look at the big three TDFs, TDFs in 2008 to 2010 lost between 20% and 28%, but the idea is that [the funds] should have a lower risk profile as investors near retirement. All those TDFs were using bonds as a safe asset-allocation class, but bonds have bear markets, too. Beaumont Capital Management TDFs are the only ones we are aware of that have both tactical allocations to stocks and bonds to address downturns in either,” he says.

Instead of making small changes every year to the target-date fund glide path, Beaumont sets a minimum 10-year investment strategy to match the whole market cycle. “In our TDFs, we have allocations, let’s say to equity; some allocations are tactical and some are strategic. Strategic allocations do not change over each 10-year period; they become fixed so that, regardless of the market, they stay invested. Tactical allocations have the ability to leave equity and go to cash if one sector, or the whole market, goes into a period of failure,” Haviland says.

Beaumont’s TDFs go “through” retirement. “We believe our at-retirement allocation is appropriate for those 60 or older because we have a large portion of the portfolio that can raise cash in a bear market. It’s about not losing a lot of money,” Haviland says.

One final point he makes is that Beaumont believes a target-date fund should be easy to understand, transparent and flexible. When ETFs are used versus mutual funds, investors can look up holdings intraday; mutual funds will not disclose holdings until 30, 60 or 90 days later. “ETFs are efficient vehicles to manage TDFs,” Haviland says.

Retirement Income
Dimensional Fund Advisors’ Target Date Retirement Income Funds seek to address key factors of investing by managing the market, interest rate, and inflation risks leading up to and throughout retirement.

Steve Clark, global head of institutional services at Dimensional Fund Advisors in Austin, Texas, says, when the company looked at the target-date fund landscape, it thought the funds were addressing the wrong goal. “DC plans are being used as an alternative to [defined benefit (DB)] plans. To do this effectively, they should focus on retirement income,” he says. “The evolution of DC plans toward income replacement has had many challenges along the way; plan participants don’t have the time, training or desire to [manage their accounts for that purpose] well in most cases.”

Defined contribution participant investment allocations should change over time, and though target-date funds address that, investment managers at Dimensional disagree with the glide paths that move solely to shorter-term fixed income to become more conservative. “Participants don’t need a pool of money but a source of money to sustain spending in retirement,” Clark says.

Dimensional Fund Advisors’ target-date funds have a certain level of income as the goal, as defined benefit plans do. “Much like DB plans, we use liability-driven investing [LDI], hedging liability and duration matching of liability with inflation protection,” says Clark. “Inflation can very easily eat into money saved for retirement. Participants can have the most secure assets, but if inflation is high, they’ll have less for consumption,” he says.

Risk Management
Last year, Wells Fargo Asset Management introduced its Wells Fargo Dynamic Target Date Funds, a suite of investments designed to help retirement plan participants reach the recommended 80% income-replacement goal post-retirement.

“In the years leading up to retirement, a glide path arguably needs to be aggressive enough to meet the participant’s investment goals, yet also be conservative enough to hedge against market losses—particularly, close to retirement,” says Ron Cohen, head of defined contribution distribution for Wells Fargo Funds Management LLC in Boston. “But it’s difficult for a standard glide path to be both aggressive and conservative at the same time. Wells Fargo Asset Management has developed a new approach that’s intended to address this challenge.”

Besides creating a broadly diversified portfolio with enough equity exposure to help participants achieve their target goal, Wells Fargo portfolio managers Christian Chan and Kandarp Acharya, both in San Francisco, employ a set of institutional-caliber risk management techniques, including tactical asset-allocation and a patent-pending dynamic risk-management approach.

What Advisers Should Seek
Castille notes that target-date funds are as broad an investment category as equity mutual funds. Retirement plan advisers should look at what the fund is trying to do—be it capital preservation, sustained spending in retirement, growth, etc.—and align that objective with what their client wants to do. Also, he says, advisers need to realize that such funds have a longer investment horizon than any other fund category, so they should look for firms that have made a commitment and demonstrated success.

Finally, he recommends that advisers understand the research process that TDF managers follow. “Clients are not only buying today’s product but the research process that defines how the fund works 10 to 20 years down the road. They have to think about how the TDF works over an investor’s lifetime,” Castille says.

Clark agrees that advisers need to look at what their clients are trying to do for their plans, whether this is to create a pool of wealth for making purchases or to replace a stream of income. “They need to look at how much income a participant needs during retirement and make sure the underlying assets of the TDFs are managed in a way to provide that,” he says.

As for where the funds are going, Castille believes they will evolve around helping people solve retirement income problems—managing longevity risk and market risk at the same time. “It could be in the form of annuities or a draw-down strategy. This is another area where research will lead to innovation,” he says.

Clark says Dimensional Fund Advisors has been working on income solutions in retirement for five or six years, and it is excited about making a product available in a commingled solution. “We can deliver in models and TDFs, with expense ratios in the low range from 21 basis points [bps] to 29 basis points—well below the industry average,” he says. “We see focusing on income as the future of retirement plans.”

Key Takeaways

• TDF providers are considering product evolution to improve participant outcomes;
• Newer TDFs address cost concerns, market volatility and retirement income; and
• Advisers should make sure TDF strategies align with what clients want.