Target Date Funds Gain Traction With Plan Sponsors But Issues Persist

MFS Defined Contribution Investment Trends Study.

KEY FINDINGS

  • A recent MFS survey of DC plan sponsors and advisors shows that performance is the most important criterion used to select target date funds. Factors that have a significant impact on performance, such as expenses, risk management and glide path design, are also cited as important criteria.
  • Plan sponsors and advisors have a high degree of confidence in the ability of target date funds to meet participant needs, but there are also concerns regarding risks that could undermine participant success. Risks cited include volatility, as well as interest rate risk and liquidity risk.
  • Survey respondents also report concerns about benchmarking performance and managing risks.

A recent survey of plan sponsors and advisors confirms the growing importance of target date funds (TDFs) in defined contribution plans. While the survey shows that respondents have a high degree of confidence in the ability of TDFs to meet the long-term needs of plan participants, plans still struggle with a range of issues, including manager selection and risk management.

Key factors in choosing target date funds for DC plans

Survey responses show that investment performance is one of the most important criteria that DC plans sponsors consider when selecting a target date fund for their DC plan, as cited by 64% of respondents. A further 46% of respondents cite fund expenses as one of the most important criteria (see Exhibit 1). The lessons of the last market downturn may be fading from the collective consciousness of many plan sponsors; nearly 6 in 10 plan sponsors report considering a track record of three years or less when selecting managers. Interestingly, while only 12% of respondents say they rely on one-year performance to select a manager, 26% say that they would review a manager who underperformed over a one-year period.

While a focus on performance is understandable, sponsors also cite several additional factors that have a significant impact on performance: asset allocation, risk management and the construction of a target date fund’s glide path.

 

Volatility and retirement outcomes

Nearly three-quarters of plan sponsors surveyed have a high degree of confidence in the ability of TDFs to meet the long-term needs of participants. Yet plan sponsors are very aware of risks that can undermine retirement savings. Volatility risk is the most important risk factor for survey respondents, cited by 40% of plan sponsors and 44% of advisors (see Exhibit 2). The impact of volatility risk is different at different points in the lives of plan participants. Participants who are nearing their planned retirement date have fewer years to recover from market downturns, while early-career participants often have an investment horizon of several decades.

A target date fund’s glide path reflects this difference in risk tolerance between older and younger investors. Roughly one-third of respondents expressed a preference for a “to-retirement” glide path; a similar percentage preferred a “through-retirement” glide path. As participants near their planned retirement date, to-retirement glide paths usually seek lower volatility and reduced risk of loss by lowering exposure to risk assets such as equities. Although through-retirement glide paths also reduce exposure to equity risk as participants age, they generally maintain a higher equity weight than a to-retirement glide path. Usually the goal of this higher equity weight is to seek higher returns — at the price of increased risk — so that assets are able to last “through” a long retirement.

 

However, research has shown that more than 80% of plan participants withdraw all their assets from their 401(k) plan within a few years of retiring or changing jobs, so few participants are actually invested in TDFs late in retirement.1 As a result, in practical terms, the “to” versus “through” distinction is less about longevity risk and more about the volatility risk borne by late-career participants. The 2008 global financial crisis provides an example of the impact that differences in volatility risk can have. Nearly all target date funds had negative performance between the equity market peak in November 2007 and the market low in February 2009, but there were sharp differences in performance between funds with a to-retirement glide path and those with a through-retirement glide path. Among funds intended for investors planning to retire in 2010, the average through-retirement fund had a peak-to-trough loss of 27.16%, while the average to-retirement fund lost 19.76% — more than 700 basis points less (see Exhibit 3).

Managing risks and measuring performance

Sponsors also cite risk management and asset allocation as important criteria in manager selection, at 36% and 40% respectively. Yet plan sponsors may be confused about the ability of their investment offerings to provide risk management. While 49% of surveyed plan sponsors were aware that passive investments bear full market risk and are unable to provide risk management, the remainder mistakenly believed that passively managed funds have less volatility than the market.

Though investment performance looms large for plan sponsors, many have struggled with how to benchmark the performance of TDFs. Since TDFs all have different glide paths, some plan sponsors and advisors feel that benchmarking TDFs is impossible; 14% of plan sponsors and 15% of advisors fall into this category. Still, 43% of plan sponsors believe that comparing performance to a peer universe of other TDFs is the best approach to benchmarking.

Looking toward the future of target date funds

In 2014, nearly one-third of new DC contributions were invested in target date funds, up from a tiny share when TDFs were first introduced in 1994.2 While early target date funds were often “proprietary” funds managed by a plan’s recordkeeper, the target date landscape has evolved significantly since. Fifty percent of plan sponsors surveyed offer TDFs managed by someone other than their plan provider, and 85% of advisors surveyed recommend actively managed nonproprietary funds to their clients; further unbundling of investment and recordkeeping is therefore likely.

Nearly 80% of plan sponsors are concerned about participant success in retirement, and volatility is their leading concern. With target date funds increasingly crucial to the retirement security of more than 80 million Americans participating in DC plans, we are likely to see an increased focus on risk management and portfolio construction for these funds.

 

 

Target date funds may not achieve their objective and/or you can lose money on your investment in the funds. You may experience losses near, at, or after the target date. There is no guarantee that the funds will provide adequate income at and through your retirement. For assistance in determining your financial situation, consult an investment professional. 

 

1Cammack Retirement Group, “A Better Methodology for Monitoring Target Date Funds,” 2014.

2Northern Trust, May 2015

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