Right On Target? Examining Target Date Funds in the Post-2008 Environment

By Karl Mergenthaler, CFA, Veda Eswarappa and Diana Jiang
karl.c.mergenthaler@jpmorgan.com, veda.eswarappa@jpmorgan.com, diana.a.jiang@jpmorgan.com

Following the introduction of Target Date Funds (TDFs) in the early 1990s, some hailed these managed portfolios as a panacea of sorts. Historically, inertia and lack of knowledge prevented many investors from adjusting retirement plan asset allocations over time. With TDFs, some believed investors could simply choose a fund with their retirement date and let investment professionals handle everything else. Others were skeptical of this “easy fix” approach and warned that TDFs could not successfully account for varying lifestyles or risk appetites. This sentiment prevailed in 2008, when some TDFs lost 40% of their value two years before participants would retire.

In many ways, Target Date Funds address the key concerns and objectives of Defined Contribution (DC) plans. TDFs may provide a cost-effective, transparent solution for DC Plans. Moreover, TDFs may provide better retirement outcomes for the majority of participants as the portfolios manage investment risk over time. As such, we believe that TDFs will continue to gain importance and popularity in the DC market.

Plan sponsors face an array of Target Date Fund options in the marketplace today. DC Plan Sponsors must evaluate the strategy and structure of potential TDFs in order to select a plan that is best suited to their needs. In this article, we identify and analyze key topics concerning TDFs, including asset allocation, fees, architecture, and strategy. We seek to help plan sponsors understand what causes the range of outcomes and potential problems with Target Date Funds.

Background on TDFs

Target Date Funds, also known as lifecycle or age-based funds, are investment vehicles whose “glide paths” shift to a more conservative asset allocation as the end date approaches. These funds can be used for everything from 529 college savings plans to DC retirement plans. TDFs surged in popularity following the Pension Protection Act (PPA) of 2006, which designated them qualified default investment alternatives (QDIAs). The QDIA status limited fiduciary liability, encouraged DC eplan sponsors to automatically enroll employees, and helped create a $47.5 billion net inflow to TDFs in 2010, leading to a total investment in open-end TDFs of over $340 billion.¹ Although the PPA also listed other QDIAs such as balanced funds and professionally managed accounts, TDFs are the most popular choice, accounting for 57% of all QDIA options, according to Morningstar.²

Three firms – Vanguard, Fidelity and T. Rowe Price – currently dominate the TDF space, having captured 76.1% of the 2010 market share.³ Other players – especially those who have entered in the last five years – have gained market share in recent years. At this time, the TDF market is comprised of over 20 major players with varying investment styles and asset allocations. We illustrate this in Exhibit 1.

Exhibit 1 — Market Share of Target Date Funds

Source: Morningstar

Portfolio Construction

In order to analyze the various Target Date Fund options, we performed a back test of ten institutional TDF managers that display a wide range of sizes, structures, and objectives using historical index data for relevant asset classes. We illustrate the performance of these funds in Exhibits 3 and 4.

There is a wide range of potential risk and return outcomes for the available Target Date Funds. Based on our analysis, funds with lower levels of equity and greater diversification, especially in commodities and TIPS – such as Fund B – would have achieved higher overall returns over the past decade.

It is apparent that asset allocation can vary greatly among Target Date Funds. In Exhibit 2, we summarize the range of allocations to major asset classes among the 2020 and 2050 Target Date Funds in our analysis.

Exhibit 2 — High and Low Asset Allocations in 2050 and 2020 Target Date Funds

Based on our analysis, there can be a significant difference in the asset allocation of Target Date Funds even if the date is the same.

Exhibit 3 — 10K Investment Returns for 2050 Target Date Funds

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Exhibit 4 — 10K Investment Returns for 2020 Target Date Funds

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Source: Bloomberg, Fund Prospectuses

For the 2050-dated funds, there was a large differential between the lowest U.S. equity allocation (30%) and the highest (69%). Similarly, there is a wide range in the exposure to developed and emerging market equities. In terms of fixed income, funds held between 1.7% and 13% in bonds. The fund with the 13% allocation held almost half in high-yield or below-investment-grade bonds, allowing some diversification benefits. However, this allocation also contributed to greater losses during periods of economic downturn. Only three funds held emerging market debt, with a maximum 2% allocation.

Overall, the 2020 allocations are more conservative than 2050 funds. Nonetheless, there is a wide range of allocations to domestic equities with the highest allocation being 55.2%. As expected, 2020 funds have a higher allocation to fixed income securities than 2050 funds; allocations to fixed income investments for 2020 funds ranged from 21.4% to 52.5%.

One material difference among various Target Date Fund offerings is the use of alternatives. Many TDF offerings invest primarily in traditional assets and avoid alternatives such as emerging market debt, commodities and real estate. However, Target Date Fund managers have recently begun expanding into nontraditional asset classes. Providers are adding alternative investments ranging from commodities to TIPS to spread risk across diverse investments. These specialized asset classes aim to combat inflationary effects and smooth volatility.

Traditionally, advisors have been hesitant about alternatives for two reasons. Since many participants are not extremely knowledgeable about financial markets, advisors may prefer traditional classes their clients might know better. Closed TDF advisors might also be adverse to nontraditional classes their provider does not offer.

However, the market in 2008 highlighted the importance of diversifying portfolios and some well-established providers began expanding into specialized asset classes. Newer entrants to the TDF market made more substantial allocations to alternatives, signifying a transition in TDFs and DC investments in general to become more complex and “DB-like” instead of solely containing stocks and bonds.

For example, Fund B, which entered the TDF market in 2008, has the highest allocation of the funds we studied to both these asset classes. The performance of this fund stood out, consistently realizing higher returns than other funds. This appears to be partially attributable to material exposure to TIPS and commodities. Although Fund B’s strategy looks compelling, the approach is quite new and there is no guarantee these assets will continue to be effective diversifiers. Plan sponsors should look for additional evidence and consider longer term performance over multiple market cycles.

Based on our analysis, the performance of Target Date Funds in various economic environments can differ materially. We studied the performance of TDFs in four market environments: high/low growth and high/low inflation. For example, 2050 funds with high exposure to commodities performed the best when inflation and growth were high. Conversely, funds with the highest allocation to fixed income performed the best in periods of low inflation and growth. Given the array of potential outcomes, DC plan sponsors should realize that the wide range of asset allocation among TDF offerings can have a material impact on the ultimate investment success of plan participants.

Focus on Fees

There is a wide range of fees for the funds in the marketplace today. In our analysis, the 2020-dated funds had an average fee of 0.76%, with individual fees ranging from 0.19% to 1.27%. For the 2050-dated funds, the average fee was 0.85% and individual fees spanned from 0.19% to 1.57%. Actively managed funds often charge higher fees than passively managed funds, since active managers attempt to beat the market with their own analyses while passive managers try to match market returns. Some managers have begun embracing a hybrid approach where they invest in a combination of active and passive strategies. Such managers actively manage investments they feel they can add value to while passively managing the rest, thereby lowering fees while allowing investors to benefit from managers’ areas of expertise. However, our analysis did not reveal a direct correlation between higher fees and stronger performance.

Plan Architecture

Target Date Funds can be broadly categorized as open or closed. Closed TDF advisors include only managers from their own firm in the series, so advisors are likely to better understand managers’ investment processes and objectives.⁴ From the advisors perspective, this arrangement may be preferable since they would not have to deal with a sub-advisor and keep all management fees.

One disadvantage of closed architecture is a potential conflict of interest. A manager might undertake additional risk and over-allocate to more profitable, higher-cost investments. Open TDFs avoid this issue by separating glide path and fund selection from investment management. However, only a few funds use open architecture.

DC plan sponsors also have the option of creating a custom Target Date Fund for their own plan participants. This route might appeal to those who do not want off-the-shelf funds, regardless of architecture. Custom TDFs afford plan sponsors the freedom to choose how to structure and oversee their plans. This approach seems best suited to large corporations that have the resources and expertise to manage a TDF glide path in-house.

Benchmarking

Performance measurement for Target Date Funds can be a challenge because there are no universally accepted benchmarks. Varying investment objectives, glide paths, and target dates complicate comparisons. Some believe the best metric is the retirement income replacement ratio: the percentage of yearly preretirement income that will be supplied per year in retirement.

In addition, there are three general benchmarking methods. The first is a custom composite benchmark, a hybrid that closely resembles a TDF’s asset allocation and demonstrates how the fund performed relative to underlying indices. For example, if a TDF contains 30% U.S. large-cap equity, the benchmark could have a 30% S&P 500 weighting. We believe this method is the most promising. It would help investors determine if their portfolio’s active management added value, as the benchmark is a passive comparison.

The second, “peer group” approach compares fund performance to other TDFs. One would select funds with similar allocations or risk characteristics, perhaps using indices supplied by groups such as Standard & Poor’s. This could help investors evaluate strategy performance relative to other market options. However, it is difficult to find a peer group with all characteristics similar to one particular TDF.

The third approach uses benchmark-specific target date indices whose shifting glide paths facilitate comparison.⁵ Morningstar and PlanSponsor offer benchmark indices with varying risk profiles while others offer just one risk level.⁶ Target date indices can be a convenient way to make comparisons, but the limited options available mean they might be less effective for TDFs with different characteristics.

Conclusion

Since their creation nearly two decades ago, Target Date Funds have attracted many investors and hundreds of billions of dollars. Despite their disappointing performance in 2008, TDFs have mostly recovered their losses and continue to appeal to DC plan participants. By 2015, TDFs are expected to account for three-fifths of DC assets and capture $1.5 trillion in flows.⁷ Although we know TDFs are not a cure-all for every investor, we do believe they can be an effective investment tool if used wisely. Plan providers and sponsors must properly educate participants about the properties and risks of their funds. If sponsors and participants fully understand what they are investing in, they can select plans that will best suit their needs and help them achieve their investment goals.

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