Current Volatility Shows Weaknesses in TDFs

During this period of pronounced volatility caused by the coronavirus pandemic, target-date fund (TDF) returns can vary widely due to different glide paths, says Jason Shapiro, director, investments, at Willis Towers Watson.

“For those who are young, the consensus is that they need growth through equity exposure,” Shapiro says. “So, for those funds from the fifth to the 95th percentile, their returns have ranged from negative 17% to negative 23% in the first quarter.” The broad equity markets were down 21%.

Returns for TDFs for those retiring near 2025 have ranged from negative 5% to negative 14%. The funds returning negative 5% are the “to retirement funds,” which fully de-risk at the point of retirement, Shapiro notes. The funds returning negative 14% are the “through retirement” TDFs, which have much higher equity exposures.

“The point is, these funds are designed to do very different things,” Shapiro continues. “Those two objectives—protection and growth for another 30 years—go head to head. Sponsors need to be cognizant of the very large dispersion in the universe, which is really stark in such a volatile market.”

While many believed that TDF managers made a point to diversify their portfolios following the Great Recession in 2008/2009, that actually did not happen, Shapiro contends. “We haven’t seen the TDF universe change substantially.”

He says he believes TDF managers need to do a much better job of diversifying their holdings beyond equities and fixed income into real estate, commodities, high-yield emerging markets and other credits. “Off-the-shelf glide paths have not evolved to provide protection,” Shapiro says. “They should also include retirement income provisions.”

Because TDFs have not really evolved, he believes retirement plan sponsors need to scrutinize their holdings and glide paths.

Bransby Whitton, executive vice president and product strategist at PIMCO, agrees with Shapiro that TDFs’ supposed “diversification in the first quarter failed. TDF vintages most appropriate for a 60-year-old declined by as much as 25%, whereas the S&P 500 was down 30%. The declines were the most pronounced for the ‘through retirement’ TDFs.”

Whitton says even though the “through retirement” TDFs are meant to protect investors for another 20 to 30 years, “ultimately, for the age 60 and older cohort, these funds have too much risk.”

Like Shapiro, Whitton says that following the Great Recession and TDFs’ poor performance, “the TDF industry impressed upon investors the need for diversification. Up until the first quarter of this year, we had no reason to doubt these messages. The is a real wake-up call for those who believed they were in a fund with a diversified glide path. Changes were not made.”

Whitton says he believes TDFs need to be better diversified. “We argue that when you think about diversifying the glide path, you need to look beyond core bonds to other sources in the fixed income market,” he says. “We think Treasuries and TIPS [Treasury Inflation-Protected Securities] can make sense.”

Rick Fulford, head of PIMCO’s defined contribution (DC) business, expects the dismal returns of TDFs in the first quarter will prompt retirement plan sponsors “to take a much closer look at the risk in their target-date funds, particularly for those near retirement. More than ever, plan sponsors are interested in retaining retirees in their plans. They need to deliver for that cohort.”

For the past 14 years, PIMCO has conducted its annual Defined Contribution Consulting Survey to ask plan sponsors about their top priorities, Fulford notes. “Their No. 1 priority this year was reviewing their target-date funds—and that was before this downturn. They’ll learn that their TDFs probably had more risk than they knew. They will likely be asking if their TDFs’ glide paths are sufficiently diversified—across asset classes, regions and sectors, and whether there is too much U.S. bias or equity risk. They should also be asking their TDF provider if volatility management is a high priority, especially for those near or in retirement.”

Jake Gilliam, head multi-asset strategist at Charles Schwab, says the TDFs his firm offers are well-diversified, particularly for those near or in retirement. “Since the crisis of 2008, we have increased the diversification in our funds, into such things as TIPS, global real estate and various types of fixed income,” Gilliam says. “Diversification has played a strong role in limiting volatility.”

Gilliam says this has encouraged near-retirees and retirees to remain invested. He says plan sponsors will have “detailed questions for those target-date funds that did not hold up so well.”