P-Solve Report Questions Some Common TDF Manager Practices

A new white paper published by P-Solve presents a simplified framework to help retirement plan fiduciaries improve the effectiveness and efficiency of target-date fund monitoring—comparing the choices of TDF managers with the established practices of major defined benefit (DB) pension plans.

According to the research, despite the complexity of target-date funds (TDFs), there are some major features common to most TDFs’ structures that should form the basis of ongoing comparisons and analysis. These are the TDF asset allocation, especially the overall level of equity exposure and the quality of equities held; the management style, including active and passive management decisions, use of proprietary funds, and strategic versus tactical asset allocation; and finally, the fairness of fees.

If these factors are not evaluated carefully and on a manager-by-manager basis, this could result in a mismatch between an employer’s goals and participant investment results, researchers warn.

Concerning the monitoring of asset allocations, the researchers observe how the largest TDF managers “take very high levels of stock market risk in longer-term funds, ensuring that participants will bear the full brunt of any market downturn.” Even shorter-term funds have relatively high levels of stock exposure, researchers explain, higher than what is typically found in DB pension funds.

“While appropriate for some participants, heavy reliance on equities is almost certainly not suitable for as many 401(k) participants as the allocation of the largest TDF managers suggests,” P-Solve argues. “TDFs are built mainly for favorable economic and market environments.”

According to P-Solve, the typical DB pension fund, intended to operate in perpetuity, allocates approximately 60% to 70% of its assets to equities and riskier, growth-oriented asset classes, and the remainder to more conservative asset classes, including government and corporate bonds. Longer-dated TDFs, however, routinely allocate 80% or more to equities, the researchers note.

“The premise behind high-equity allocations for younger investors is reasonable: stocks tend to go up over time as the economy and company earnings grow, and investors with longer-horizons can, in theory, tolerate even sizable market declines providing recovery follows,” the paper explains. “And investors should diversify their relatively high stock of ‘human capital’ with other investments, like stocks. In some cases though, TDF stock exposure may be too high. Consider that pension funds, unlike individual 401(k) plan accounts, are intended to operate indefinitely, and can in theory take more risk than any individual.”

Researchers point out that the typical pension fund participant is approximately 50 years old and eligible to retire in about 15 years, and that the assets invested on their behalf are allocated roughly 65% to riskier investments. The same investor, if assigned to a 2030 or 2035 vintage TDF, would be exposed to 70% to 75% equities—a meaningful overweight to stocks relative to DB plans.

As the paper lays out, in 2008, when the broad U.S. stock market declined by about 37%, this overweighting harmed retirement prospects. Indeed, as the researchers note, TDF losses in 2008 were, on average, equal to or greater than those experienced by the S&P 500, despite their diversification.

Researchers go on to observe that few professionally-managed DB pension funds employ active management exclusively.

“Recognizing that some asset classes are more fertile ground for a skilled active manager than others, DB plan sponsors tend to use a blend of active and passive management,” the paper states. “The largest TDF managers by assets, other than Vanguard (naturally), have reached the opposite conclusion however: they use mostly active management.”

Researchers celebrate the fact that TDF fees continue to fall, benefitting the marketplace as a whole.

“At the end of 2016, the average asset-weighted expense ratio was 0.71%, according to Morningstar, while as recently as 2011, the average was 1%,” P-Solve notes. “This improvement is due in part to the increased use of passive funds, but also to fee reductions. The trend is positive, but on average TDF remain as, or more, expensive than actively-managed mutual funds. The average 401(k) equity mutual fund management fee is about 0.48%, and the average bond fund fee 0.35%. The average TDF fee of about 0.70% thus seems high relative to any blend of stock and bond funds, even accounting for strategic asset allocation advice, rebalancing and other features.”

TDF fees should continue to decline as assets grow, researchers conclude.

The conclusion in the paper is that the “typical TDF takes high levels of equity risk, attempts market timing that is unlikely to be rewarded on average, uses much more active management than most pension funds, and is expensive.”

“High equity exposure forced many to delay retirement, or accept a reduced standard of living in retirement, during the market crash that accompanied the Global Financial Crisis of the last decade,” P-Solve warns. “Though a repeat of this episode seems unlikely, even a less-severe downturn could result in permanent losses for those on the cusp of retirement. Retirement plan sponsors should give strong consideration to TDF managers that avoid extreme reliance on equities, refrain from excessive tactical tilts unlikely to be rewarded on average, and charge fees that are reasonable considering expected performance.”

To request a copy of the full white paper, contact article author Marc Fandetti of P-Solve at marc.fandetti@psolve.com.