Total assets in target-date funds hit the $880 billion threshold in 2016, adding $120 billion in value over the previous year to mark yet another all-time high.
Continued positive inflows from participants in defined contribution plans, which overwhelmingly favor TDFs as a qualified default investment alternative (QDIA), helped fuel the juggernaut: The funds experienced $59 billion in new inflows last year, even as baby boomers continued into retirement and out of workplace retirement plans.
And positive investment returns helped too—the TDF market has increased every year since 2008, when the funds took a shellacking in the wake of the financial crisis.
Whether future returns are bolstered by organic growth, investment returns, or both—Jeff Holt, associate director at Morningstar Manager Research and one of the authors of 2017 TDF Landscape report, says it’s clear that investment management firms want in on the action.
“Those that have market share are trying hard to maintain it,” Holt told BenefitsPRO.
And those that don’t claim much share are bringing new strategies to market in the hope of convincing sponsors that their design will get workers in line with retirement goals.
“Managers are proving to be much more adaptable in how they design the funds,” said Holt. To underscore that point, he said that the roughly 40 managers Morningstar evaluates now offer 58 TDF series between them. Just 10 years ago, no firms offered more than one series, whereas last year 12 firms were offering at least two.
On balance, the increased competition is welcomed, says Holt, but it comes with new risks for sponsors and participants. “It’s a good thing in the sense that it requires providers to stay on their toes. But the danger, potentially, is if a new series is launched without a lot of conviction from investment managers, and the fund is watered down to make it more sellable.”
As more funds grapple for retirement dollars, fees on TDFs have fallen. Last year the average asset-weighted expense ratio for all TDFs, whether actively or passively managed, was 71 basis points, a remarkable drop from just five years ago, when the average expense ratio was just a hair under 100 basis points.
That too is a positive byproduct of the increasingly competitive market, said Holt. Investors are more cost-conscious than ever, and that is clearly impacting how managers design funds.
But fee compression also introduces risk when sponsors adopt the cheaper-is-always-better approach to choosing QDIAs for investment lineups.
“We’ve been proponents for low fees for a long time. That being said, TDFs are unique in that there is no such thing as a purely passively TDF,” said Holt, noting the fact that even those funds built on indexed investments must actively allocate assets along a fund’s glide path.
“There’s a lot going on underneath the hood that could overcome any fee advantage,” said Holt.
Of late, equity allocation is the most obvious management decision that, in some funds, has offset the returns generated by low fees. Over the past seven years, a 1 percentage point increase in equity exposure has generated a 6-point improvement in annual fund performance, according to Morningstar’s report.
On balance, managers’ equity allocations are largely similar for younger investors, who are naturally assigned glide paths with high equity allocations.
But as savers enter their 50s, management styles across funds begin to show considerable diversion, not just in how much the portfolio is allocated to equities, but in how subclasses of equity risk are managed.
“For the funds that are now at retirement, investment philosophy diverges the most–there is no consensus glide path,” said Holt.
In the equity bull market since the financial crisis, managers willing to overweight equities have been rewarded. “The difference in equity exposure is a huge driver of performance,” he said.
That goes for bear markets too, noted Holt. Critics of TDFs say some carry too much equity risk near or at retirement, in the effort to generate beefed up returns that attract more sponsors and investors.
“There definitely is a temptation for managers to ramp up equity exposure in a long bull market. But there are also realities that support equity risk. All TDF providers are more or less balancing different risk. When you dial one risk down you are dialing another one up,” explained Holt.
When Morningstar evaluates TDFs, investment performance is certainly considered. But it is only one factor when determining if a fund series warrants the coveted Gold, Silver, or Bronze medalist rating, given to those funds that the firm expects to outperform peers and benchmarks over at least a five-year investment horizon.
“There could be two series with a similar rating that got there in very different ways,” said Holt. “It can and does happen that funds with heavy equity exposure have not received medalist ratings during the bull market, and funds with lower equity exposure have. We’re not trying to stamp an approval rating on a single investment philosophy.”
In rating TDFs, the objective is to distinguish those funds and management teams retirement investors and plan sponsors can have faith in for the long haul.
“We’re looking to identify teams and philosophies that are backed by robust research and sound rationale,” added Holt. “Our medalist funds are not the same philosophically.”
Price is clearly a factor. But as important, if not more so, is the quality of the managers behind the funds. “We look for a team behind the scenes that is proactively revisiting the series,” said Holt. Management teams with high turnover rates are a red flag, he said.
“Investors need to be on alert for significant turnover in management, which would signal a change in investment philosophy. We’re most confident in series with deep teams, resources, and attention to the funds—where the TDF is not just a side project but is top of mind for the firm.”
Ten years ago, total TDF assets were not even at the $200 billion mark. Their role in facilitating the transition of the retirement economy from a defined benefit to a defined contribution model has been arguably as great as any other retirement tool.
But notwithstanding their ascendance, the jury is still out whether they will prove to be an adequate substitute for defined benefit pension plans.
“These are designed to be a multi-decade investment, and we are really only one decade into the experiment,” said Holt, referring to the 2006 Pension Protection Act, which green-lighted TDFs as a default investment in 401(k) plans.
For the most part, retirement investors have been well behaved once they are defaulted into TDFs; Holt says TDF investors have a low incidence of dangerous market-timing tendencies. In effect, they are staying the course.
But will that mean they will have sufficient assets to retire on? Not unless they are saving enough, says Holt. “Investors still have to put money away. TDFs don’t make up for a lack of savings.”