Simplicity of TDFs Has Eroded

When TDFs were first introduced in 1994 the notion was to aggregate all participants by the factor by which to most easily aggregate—their retirement date—use a glidepath to adjust risk over the accumulation period and at the target date, then fold the assets into an income or “preservation” fund, Craig Israelsen, a principal at Target Date Analytics noted during a webinar sponsored by Mid-Atlantic Trust Company. “The first glide paths and allocations were simple—they reduced equity over time,” he said.

But, competition in the TDF marketplace heated up in 2005 and the Pension Protection Act (PPA) of 2006 encouraged plan sponsor use of TDFs as qualified default investment alternatives (QDIAs), leading to an improvement in diversification, but also leading to what Israelsen called “an unfortunate focus shift.” According to Israelsen, there is a myopic focus on short-term performance, and the focus for TDFs has shifted from overall allocation to the underlying assets and from accumulation investing to longevity management.

“The focus on short-term performance is ironic,” Israelsen said. “It’s a target-date fund, a long-term investment, but the way companies compete for assets is to focus on short-term performance.”  He pointed out that one of the dilemmas of this focus occurred during the recession of 2008 and 2009; 2010 TDFs—for individuals only two years from retirement—suffered poor performance. “The average target-date fund, by that time, focused on short-term results, so there was too much risk in the allocation,” he said, noting that the decline was worse for the average TDF than for the Brightscope On Target Index benchmark, which is focused on maintaining assets.

He also noted that now, 2015 funds are performing below the Index. “A more conservative approach is vital,” he said, especially since cash flows into TDFs were $23 billion in the first quarter of 2013, and deferrals into the funds by retirement plan participants are increasing.

There are more than 50 target-date series and more than 500 funds in the marketplace now, and that is only counting funds with differentiated glide paths. The market is saturated; how are plan sponsors and participants to know what is best?

Joe Nagengast, principal at Target Date Analytics, told webinar attendees that since the 2008 meltdown of 2010 funds, the Securities and Exchange Commission (SEC) and Department of Labor (DOL) have held hearings, issued a joint bulletin about TDFs, proposed amendments to fund advertising and proposed enhanced disclosures, but Target Date Analytics doesn't think this will help. "The intent is to educate plan sponsors and participants, but the information is complex, so it will erode the simplicity of TDFs," Nagengast said. "To presume participants will read very complex information to explain the differences in TDFs is misguided, and plan sponsors will end up with more boxes to check and no more clarity."

Plan sponsors must still use a prudent process to select and monitor TDFs, but this entails more now than it once did, he contended. The process includes:

• Determining the purpose of TDFs in the plan—Will the series selected be yet another investment choice or the predominant investment for participants, will the series be the plan's QDIA? Nagengast said this will guide product selection.
• Evaluating glidepath structure—Are the TDFs "to" funds or "through" funds? According to Nagengast, a fund that hits its most conservative allocation at the target date is a "to" fund, all others are "through" funds. Plan sponsors and advisers must determine whose interest to serve, participants who will stay in the plan or those who will cash out. Nagengast noted that 80% of participants withdraw funds, on average.
• Evaluating equity exposure—this is similar to evaluating glidepath structure.
• Determining whether to go with funds that use active or passive management-passively managed funds follow indices and Nagengast warned attendees to avoid a consensus model index. "The average of all allocations is not smart because there are vastly different strategies," he said. Target Date Analytics recommends a mix of active and passive management: "For efficient classes the funds use an index, and for inefficient asset classes, they use active management."

Plan sponsors should be careful about the hype of using alternative investments in TDFs—real estate, commodities and TIPS are the most commonly mentioned—but they make up only about 7% of TDF assets. "Sponsors should just keep their focus on diversification overall," Nagengast noted.

Fixed income investments are coming under focus because of the increase in interest rates, so Nagengast suggested plan sponsors look carefully at the impact of duration risk at each point on a TDF's glidepath. He also suggested considering funds with no revenue sharing.

More about the On Target Index is at www.ontargetindex.com.