Target-date fund (TDF) assets ballooned to roughly $880 billion dollars in 2016, according to April’s Morningstar 2017 Target-Date Fund Landscape annual survey report. And Cerulli Research Associates estimates that TDFs will capture roughly 90% of all new 401(k) plan contributions by 2020.
Considering the kind of money flowing into the funds, and the wide variance in expenses, performance and risk factors, should plan sponsors be increasing their due diligence on these investments? The following are variables that should be considered when undertaking that process.
Advantages of TDFs
TDFs are a “set-it-and-forget-it” or “autopilot” investment. They tend to be better suited for the participant who is not financially sophisticated enough to allocate for himself. They also provide for diversification because the money will be spread over several mutual funds and be rebalanced and reallocated over time as the person’s retirement age approaches. From an administrative standpoint, they can also ease automatic enrollment.
Disadvantages of TDFs
On the down side, the glide path can vary from one of these funds to another. Some TDFs may be more exposed to risk by the time their target date arrives. Most utilize their own funds as part of the investment mix and may not be the best option within their respective asset class. The autopilot quality can also give participants a false sense of security, making them pay less attention to their portfolio over time or when the market is unstable.
Further, participants tend to use TDFs improperly. A TDF is supposed to be a one-stop shop: Pick a date you plan to retire and the TDF closest to that date. However, participants will tend to mix other asset class funds with their TDF, which defeats the intended benefit. A participant could be tactically choosing other investments to overweight an asset class or sector to improve performance, but if he is this sophisticated at allocation decisions, why would he use a TDF to begin with?
There were 143 funds in the category “Target-Date Funds 2015,” based on information collected from Morningstar Advisor, and the data presented for these funds revealed significant differences.
Net Expense Ratio
The net expense ratio ranged between .08% and 1.75%, which equates to a 1.67-point spread. As a plan sponsor, if you have the more expensive TDFs in your lineup, you had better be prepared to defend your decision to utilize them.
You would think TDFs with the same target date would be similar in their allocations. The equity allocation ranged between 24.3% and 55.8%, while the bond allocation ranged between 32.5 and 74.6%. Even the amount of cash held ranged from .52% to 30%.
Performance difference is no exception. The five-year performance ranged from 3.1% to 8.3%. Participants not getting the better returns could be missing out on thousands of dollars over time.
Lower volatility is perceived as more conservative, and standard deviation measures the volatility of a fund’s return in relation to its average.
TDFs are supposed to have a glide path toward more conservative assets, such as bonds as they get closer to the target date. In a rising rate environment, bonds can be as risky and volatile as their equity counterparts. The iShares 20+ Year Treasury Bond ETF [exchange traded fund] is a good fund, but it has a three-year standard deviation of 11.44, compared with the SPDR S&P 500 ETF, which has a three-year standard deviation of 10.04. How does a participant know if the TDF is adjusting the bond position to protect against the effect of rising rates?
Follow the Money
As a plan sponsor, are you paying fair value for an adviser if TDFs are recommended or utilized more heavily? As mentioned earlier, the funds are a “set-it-and-forget-it” investment that doesn’t require allocation changes or rebalancing.
As an example, we’ll take a $3 million plan with 50 participants, assume the adviser meets with each participant for 30 minutes twice a year and provides no other 3(21) or 3(38) fiduciary services. Keep in mind, if most assets are in TDFs, there isn’t much to talk about on visits because of the autopilot nature of the investment. If the adviser receives .50%, this equates to $15,000 a year, or $600 an hour. If we instead use an hourly rate of $150 and the same time assumption, this totals just $7,500 a year, compared with $15,000. Making this single negotiated move would result in a 50% savings staying with the plan or in the pockets of participants.
It’s not that TDFs are completely worthless. As a plan sponsor, you need to understand your participant demographics, needs, amount of service needed and any limitations of your plan provider. TDFs have been manufactured and brilliantly marketed by a very powerful financial service industry. It’s important to understand that they are not superior to other investments when it comes to performance. So, if they’re not superior to other investment options, then you should ask yourself … who stands to profit the most from their use?
Michael Schultz is president of Venn Wealth & Benefit Services, LLC. With over twenty years of experience in the financial service business and a Bachelor’s Degree in Accounting from Penn State University, he has been a strong advocate for plan sponsors and participants to improve the overall effectiveness of retirement plan strategies.
The information contained herein is for informational purposes only. None of the information constitutes a recommendation by Venn Wealth & Benefit Services and is not intended to provide tax, legal, or investment advice. Venn does not guarantee the suitability or potential value of any particular investment or information source. Certain information provided herein may be subject to change. None of the information contained herein may be copied, assigned, transferred, disclosed, or utilized without the express written approval of Venn.
This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Strategic Insight or its affiliates.