PANC 2021: The Great TDF Debate: Prudence vs. Performance

Comparing the “quality” of target-date funds (TDFs) is not a straightforward operation. Plan advisers and plan sponsors must decide how to prioritize performance, risk and many other factors when making a prudent investment decision. This is especially important as TDFs have become the go-to qualified default investment alternative (QDIA) for the majority of plan sponsors.

During the opening session of the 2021 virtual PLANADVISER National Conference (PANC), Jamie Bentley, executive vice president, retirement sales, PIMCO, said it’s helpful to look at why TDFs have been the clear winner: They are an easy way for participants to get diversification, and they require no participant engagement.

Richard Weiss, senior vice president, chief investment officer (CIO), multi-asset strategies, and senior portfolio manager with American Century Investments, said there is no question that the TDF market is maturing. But, while most plans have TDFs as their QDIA, he says assets under management (AUM) for the investments have not yet peaked.

“Plan sponsors are doing re-enrollments, and there is increased education and awareness about TDFs,” he said. “The ease of use, good performance and low fees argue heavily in favor of TDFs over other solutions.”

Jon Nolan, senior research analyst, Francis Investment Counsel, said two-thirds of plans are automatically enrolling participants into TDFs.

Dan Bruns, head of managed solutions, Morningstar Investment Management, said no one can argue about the success of TDFs—80% to 90% of plans use them and most participant assets flow into them. They have also helped participants get to better outcomes.

However, he said he questions whether this is going to continue or whether it is time for disruption. “I would argue TDFs haven’t changed much materially,” Bruns said. “We’ve seen fees come down, we’ve seen passive/active blends, but by and large products now are similar to products from years ago.” But, he added, as plan sponsors move to more personalization in other benefits such as financial wellness and participants are wanting a more personalized experience, there will be an evolution to more personalization in TDFs.

“We are seeing a little innovation, such as dynamic QDIAs that marry TDFs with more personalized managed accounts,” Bruns said. “I don’t know if that will become a dominant choice, but we’re seeing movement to that, so it will be more prevalent down the road.”

Bentley said there hasn’t been a lot of evolution in TDF space, but the industry is prime for some change. “We think personalization will be that change,” Bentley said. “There are other data elements beyond age captured by recordkeeping systems that can be delivered without requiring participant engagement.”

Prudence vs. Performance

Weiss said evaluating performance is part of a prudent process for selecting TDFS; however, the ultimate goal of TDF strategies is to minimize longevity risk—the risk of running out of assets in retirement.

“No one objective is best for a TDF. That’s why the DOL [Department of Labor] recommends looking at suitability,” he said. “We see it as an adviser’s job to help plan sponsors match the right TDF strategy to their plans.

“During normal market times, the performance dispersion among TDFs is minor, but during volatile times, the dispersion blows up. It separates the weak from the strong,” Weiss continued.

Bruns noted there are vastly different performance numbers among TDFs depending on the glide path design and different manager philosophies. He said it is important for advisers to understand the products they recommend to plan sponsor clients.

When selecting QDIAs, plan sponsors should be looking for performance, but also should be considering protecting participant assets, Nolan said.

“It always comes back to performance; plan sponsors should make sure they select options that outperform most of time,” he said. “But before looking at performance, we have conversations with clients about suitability. What is the plan sponsor trying to accomplish for participants? What would the plan sponsor prefer participants do at retirement: stay in the plan or take their money? Those things really matter when selecting TDFs.”

Nolan added that it is important to look at plan demographics. For example, if participants have access to an open defined benefit (DB) plan, they might not need to take so much equity risk.

“Even with no DB plan, there are vast differences in employee cohorts,” Bruns noted. “For example, there’s a difference between physician practices and blue-collar industries. One has higher-paid employees, higher retirement balances and higher savings rates. A glide path would be different than for the opposite.”

He suggested that following suitability, plan sponsors and advisers should consider performance and whether a TDF is managed appropriately over time. “Looking at suitability first will result in higher employee stickiness and higher retirement success, which is more important than a few points of greater performance and a few basis points [bps] in lower fees,” Bruns said.

He added that measuring retirement readiness would be helpful in knowing if the TDF is suitable for participants.

Bentley said PIMCO’s annual consultant survey finds roughly 74% of plans that consultants oversee prefer or actively seek to retain participants’ assets in the plan after retirement.

Nolan said when participants stay in the plan, it helps build economies of scale that reduce costs and allows retirees to receive education and advice.

“If you want to return chase and wait 40 years, TDFs will probably end out ahead,” Bentley said. “But individuals have different entry and exit points that plan sponsors need to be conscious of.”

As an example, Bentley said the U.S. equity market is about 56% of the global equity market, but TDFs hold about 65% in U.S. equities because they outperform in the short term. He noted, however, that there may be less performance dispersion between U.S. equities and non-U.S. equities in the longer term. So while participants are reaping the performance benefits in the short term, Bentley queried how they will do over a longer period of time.

Bentley also noted that many TDFs are developed for the “average” participant, using Employee Benefit Research Institute (EBRI) data or some other information on participants. Some plan sponsors use custom TDFs, but many do not have the expertise or money to do that, which is why data is important to make more personalization available in TDFs without disrupting the ease of use. “If we can personalize TDFs on an individual level, that takes care of the suitability issue,” Bentley said.

Weiss noted that plan demographics and plan sponsor and participant risk attitudes may change over time, so some plan sponsors change TDFs because of a change in suitability for their plans. Nolan said any TDF a plan sponsor selects won’t fit all its participants, but they should try to do the best for most participants.

“If we go through an initial suitability analysis, it is easier to talk to plan sponsors about considering risk,” Nolan said. “Participants don’t have a concept of how much risk is baked into TDF strategies. Plan sponsors should not just look at returns, but risk-adjusted returns. And they need to understand the market will go down sometimes, so how much risk will be harmful to participants?

Nolan said most TDF analyzing tools his firm sees come from TDF providers, so there’s a bit of skepticism that they will skew toward their products. Bruns noted that Morningstar has a TDF analyzer tool.