BenefitsPRO interviews Jason Shapiro, director, investments at Willis Towers Watson about TDFs, participants nearing retirement, and a widely and broadly predicted future recession. (Photo: Shutterstock)

For target-date fund investors, it’s been a decade of smooth sailing.

Since the bull market began in March of 2009, both the Dow Jones Industrial Average and the S&P 500 have posted 300 percent gains.

While market analysts and economists debate when the next recession will hit—JP Morgan puts the chances at 80 percent within the next three years—no one doubts its inevitability.

Some are saying it will be harsh when it comes. In a recent interview with CNBC, Sam Stovall, chief investment strategist of U.S. equity strategy at CFRA said the likelihood is “for a very deep bear market when it does hit.”

How deep? Stovall expects equity markets will drop 40 percent, to effectively the market highs before the 2008 recession. Stovall bases his prediction on the fact that the current bull market has lasted three times as long as the average bull market since World War II.

Stovall said he doesn’t see the signals that would forecast a recession in the next year. But its arrival “is just a matter of time,” he added.

Passive flows dominate TDF market

The TDF market eclipsed the $1 trillion market in 2017, according to Morningstar’s 2018 Target Date Fund Landscape report.

About $70 billion flowed into TDFs last year, an all-time high. But the headline story from Morningstar’s report was the dominance of passively invested TDFs, which accounted for an astonishing 95 percent of estimated TDF flows.

“That is a massive amount, and a huge reversal from what we’ve seen historically,” said Jason Shapiro, director, investments at Willis Towers Watson, in an interview with BenefitsPRO.

Sponsors’ “laser” focus on fees, spurred by a decade’s worth of lawsuits brought under the Employee Retirement Income Security Act, explains the seismic shift in flows, said Shapiro.

But for TDF investors who are nearing retirement—and for the sponsors that are offering older workers options that are predominantly indexed—the virtues of passive investing stand to be challenged if forecasts of a 40 percent drawdown in equities come to fruition during the next recession.

“TDFs have been a great instrument for asset allocation, and correcting misallocation,” said Shapiro. “But defined contribution plans, and their qualified default investment alternatives, are being asked to do more than they have in the past.”

Saving for retirement is as much about spending in retirement, notes Shapiro. “Now we’re asking TDFs to be a full vehicle for a retirement readiness plan. The question is–do participants have the ability to save and then provide for a stable spending stream in retirement?”

Are TDFs the right vehicle to support sustainable income streams in retirement? Perhaps, says Shapiro.

But an inevitable recession could highlight limitations to passive investing, and the prevailing glide-path design of TDFs, particularly for those near retirement or newly retired.

“If we do experience an event, those with higher equity exposure could see significant drawdowns,” said Shapiro. “If participants are cashing out their 401(k)s at retirement, and a shock comes, that would crystalize the losses. If not done thoughtfully it could delay a person’s ability to retire.”

Passive funds will be more exposed to market fluctuations compared to actively managed funds, which have the flexibility to create more protection on the downside, said Shapiro.

“Passive funds are more exposed to market fluctuations,” he said.

To be clear, the amount of TDF assets in actively managed funds is still more than savings in passively managed funds—Morningstar puts the split at 58 percent of assets in active funds, 42 percent in passive funds.

While Morningstar’s report does not break out the age of participants investing in passive TDFs, other data suggests much of the flow is coming from younger participants that have plenty of time to recover from a market swoon, no matter how uncomfortable it may be.

Vanguard is by far the largest TDF manager, with $381 billion under management at the end of 2017. According to the firm’s annual How America Saves report, nine in 10 plan sponsors serviced by the firm’s recordkeeping arm now offer a TDF. Two-thirds of participants that own a TDF have their entire account invested in a single target-date vintage; 51 percent of all Vanguard participants are wholly invested in a single TDF.

Most of the participants invested in a single TDF—63 percent—are younger than 45.

Still, 20 percent of “pure” TDF investors are ages 45 to 54, and another 14 percent are 55 to 64.

Hybrid solutions still in their infancy

Target-date funds’ potential limitations for savers nearing retirement are certainly not lost on the retirement industry.

Fidelity and Empower are among the recordkeepers that have rolled out a hybrid QDIA option that defaults TDF investors into a customized, managed account option when participants reach a certain age or savings threshold.

“Hybrid solutions are just now showing up in the market,” said Shapiro. “They’re still in their infancy.”

The reality is that it may take a recession—and painful losses to 401(k) accounts for older savers—to motivate sponsors’ demand for more customized savings vehicles, which will come with higher fees than passively managed TDFs. “The next big swoon could expedite the evolution” to customized QDIAs, said Shapiro.

More plan providers are touting the capabilities of managed accounts, and the need for sponsors to balance a focus on savings outcomes with their fiduciary responsibilities, said Shapiro.

But billions of dollars in liability shelled out in the past decade, and the continuation of more claims being brought by plan participants, is causing sponsors to continue to err on the side of caution.

“Given the focus on fees, and the litigious market, it will be a slower progression,” said Shapiro. “But when the focus does turn back to outcomes, there will be solutions for more customized solutions. We think more sponsors would start to consider them then.”

In the meantime, sponsors need to be conscious of investment menus’ consistency with participants’ behaviors.

“We need to be more concerned with risk management closer to retirement. Sponsors need to understand the risk levels in passive TDF glide paths—some hold much higher risk levels in equities near retirement. The spread can be as much as 15 percent. Other TDFs fully de-risk as glide paths reach retirement age,” said Shapiro.

While some actively managed TDFs may have the chance to prove their value when the next bear market comes, sponsors still need to be conscious of their construction.

“With active funds, there are some challenges with diversification with off-the-shelf products. A lot of active managers build TDFs with 100 percent proprietary funds. The challenge is that one asset manager may be really strong from a research perspective in one area, but not in all areas. It’s hard to find one shop that is best in class in all asset classes,” said Shapiro.


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