The Dimensional Fund Advisors 2020 fund is managed for 15 years after the retirement date. In hedging against inflation, the series is designed to provide a more certain income stream during the decumulation phase of investing. (Photo: Shutterstock)

Tim Kohn thinks the $1.4 trillion target-date fund market is suffering from a herd mentality.

“Everyone is doing the same thing,” said Kohn, head of defined contribution services for Austin, TX-based Dimensional Fund Advisors.

With $596 billion in assets under management, Dimensional has built a reputation over four decades on the academic purity of its research and approach to investing.

In 2015, the firm entered the target-date fund market — Kohn calls the series a target-date income fund, or TDIF — with a novel strategy of infusing the liability-driven investment (LDI) principles common to defined benefit pension management into a defined contribution product.

In keeping with its academic reputation, the firm studied the market and TDF construction carefully before rolling out its Target Date Retirement Income series, according to Kohn.

“We could have created a 'me too' product back in 2006, but there's no thought leadership in taking your funds and wrapping them into a glide path,” he said. “Yes, it's a target-date fund, but we really believe this is version 2.0 and a new class of TDF. We are meaningfully different, and we think for the right reasons.”

The modern 401(k) plan that was originally designed as a savings vehicle has become America's retirement plan, a fundamental shift that asset managers have failed to evolve with, thinks Kohn.

“Every other manager is focused on accumulation and saying 'all right, good luck' when savers reach retirement age,” he said. “Industry has spent way too much time focusing on individual inputs — types of funds, performance, fees, expenses. Those are important, but we need to be focusing on outputs. In retirement, income is the outcome.”

Organic growth even as funds flow to passive products

By the end of 2017, Dimensional's TDF series held $615 million in assets, according to Morningstar's 2018 Target Date Landscape report. Kohn expects the series will eclipse the $1 billion threshold in 2019.

About $223.5 million flowed into the actively managed funds in 2017, even as 95 percent of the $70 billion in total TDF market net flows moved into passively managed series, according to Morningstar.

About 350 sponsors include DFA's series in investment menus. Kohn says most of the growth has come from small and midsized plans.

According to the 2020 fund fact sheet, 32 percent of assets were committed to global equity funds spread across more than 13,300 individual holdings, one of the most conservative equity allocations among 2020 vintages in the market, says Kohn. The average TDF holds 45 percent in equity exposure at retirement.

As of September 30, 65.5 percent of holdings were committed to income risk management, mostly through long-term and intermediate-term U.S. Treasury Inflation-Protected Securities, or TIPS.

The 2020 fund is managed for 15 years after the retirement date. In hedging against inflation, the series is designed to provide a more certain income stream during the decumulation phase of investing.

That gives retirees' savings protection against the “trinity of risk”—market risk, inflation risk, and interest rate risk, says Kohn.

“TIPS are the best commercial product for protection against inflation,” he said. “TDFs do not protect against those three fundamental risks. If a fund is using short-term fixed income to hedge against the risks, that is incorrect.”

Can LDI revolutionize the target-date market?

It's been a gut-wrenching few months for near retirees invested in target-date funds. Market volatility is expected to continue, as more economists and money managers are predicting a recession within the next few years that could gouge retirement savings accounts.

If that happens, Dimensional's approach may prove prescient. “Five years from now we want everyone to say the mandate is for a target-date income fund. We want and welcome competition,” says Kohn.

But an LDI-driven glide path design faces considerable hurdles if it is to revolutionize the top-heavy TDF industry, says Jeff Holt, a director at Morningstar and lead author of the firm's TDF Landscape Report.

To make inroads in the market, managers have to design a differentiated approach or compete on cost. Dimensional's series does both, says Holt.

But they are also a late arrival to the party. “It's hard to say that a firm with less than 1 percent share of the TDF market is going to revolutionize the space,” said Holt.

While the LDI approach is clearly differentiating from rank-and-file TDFs, it's also a substantial, and complex deviation from the mindset of the typical 401(k) investor.

“The typical TDF investor is most attentive to their portfolio during a market downturn,” said Holt. “They are not really thinking of the funded status of their liability. The main attraction of a TDF is for investors that don't want to be involved. Is the LDI approach in line with what those investors want from an instinct standpoint? It seems complex. To completely change that mindset will require a lot of education.”

Investors could of course be defaulted into an LDI strategy. Dimensional's series is a qualified default investment alternative. Kohn says sponsors can also legally map assets from existing TDFs into an LDI-based strategy.

But that too would require a change in mindset on the part of sponsors, whose laser focus on fees in the face of heightened fiduciary liability has accounted for increasing flows to passively managed TDFs.

“For all TDF managers, it's their responsibility to convince sponsors that their research and philosophy will lead to the best outcome for investors,” said Morningstar's Holt.

“Sponsors have shown a strong appetite for low cost options. When a solution is very different, that requires a plan sponsor with a lot of conviction in the strategy that is willing to stand out on a limb,” said Holt.

Innovation of the kind Dimensional has brought to the TDF market is unquestionably a good thing, says Holt. Time will tell if the LDI strategy resonates with sponsors and 401(k) investors, he said.

Dimensional has not set future asset goals for its Target Date Retirement Income Series, according to Kohn. “If you do the right thing, we'll be as big as we'll be.”

But he has no doubt the firm's LDI approach will flourish as the imperative on income solutions within 401(k) plans grows.

“We encourage others that have been talking about retirement income for over a decade to come along this journey with us,” said Kohn. “This is what right looks like. We know this will be an important offering for decades to come.”