Many TDFs Need to Be Adjusted for Risk

Target-date funds (TDFs) have been steadily growing in popularity, quadrupling as a portion of mutual fund assets in defined contribution (DC) plans in just over a decade, notes investment services provider SEI.

 

However, the firm observes, many TDFs are riding the wave of the bull market and pursuing generic—meaning just stock and bond—investment strategies that are overall too risky: The average TDF for the year 2020 still has 54% of its assets allocated to equities. Jake Tshudy, director of DC investment strategies at SEI in Oaks, Pennsylvania, says his firm looks at equity beta. “Five years out from retirement, we’re roughly 10% less in equity exposure [than the average target-date fund],” he says. SEI’s analysis looks at major providers of off-the-shelf TDFs, not at custom funds.

 

Tshudy tells PLANSPONSOR some of SEI’s funds are strategy funds; a multi-asset-class portfolio uses Treasury inflation protected securities (TIPS) and nominal bonds, as well as equities. SEI makes an effort to seek out risk premia, using investments other than stocks and bonds, so its TDFs are not riding the market cycle. “If a plan participant hits retirement during a market low with significant equity risk, it is not a good thing,” he says.

 

SEI also employs high yield investments and emerging market debts to manage downside risk. “They don’t fall as far as equities but approach equity-like returns and offer return enhancing performance,” Tshudy explains. He adds that SEI’s approach might look less advantageous because there is a lower allocation to equities, but this tends to create better returns on the market downside. SEI has been talking to TDF managers about deploying strategies within their investment lineup that mitigate the potential downside.

 

For plan sponsors and advisers to help determine whether a retirement plan’s TDFs are too risky, an analysis should be run, Tshudy says and adds that he is also a believer in custom TDFs. Plan sponsors and advisers should consider employees’ expected retirement age, investing patterns and estimated Social Security benefits. “We believe an actuarial valuation approach akin to a DB [defined benefit] plan is the best strategy to determine if a TDF series has the appropriate level of risk based on a plan’s demographics. For example, if participants are retiring on average at age 55, that will affect which TDFs to use,” he says. SEI’s approach to making recommendations to plan sponsors about TDFs grew out of its history in liability-driven investing (LDI) in DB plans. “We employ the same practices in the DC space.”

 

Tshudy says his advice to DC plans is to consider their TDF’s underlying allocations, determine if it is likely the market will continue its run-up, and consider diversifying so as to keep from chasing equity returns. By diversifying, he is not saying, get out of TDFs—but to consider changing to one with a more long-term allocation.