Retirement plan advisors, sponsors and participants are embracing target-date funds—perhaps to their own detriment.
Some advisors, like Ric Edelman, executive chairman and founder of Edelman Financial Services, believe that using a static risk assumption for asset classes over a client’s working life may harm his or her chances for retirement success. For plan fiduciaries, it's become more important to understand the inner workings of TDFs—at the same time, asset managers are beginning to innovate within the target-date fund space.
At the heart of Edelman’s criticism of target-date funds is that they assume that the risk and return characteristics of asset classes like stocks and bonds remain stable over time. That’s far from true, as the stability of the U.S. fixed-income market has depended to a large extent on the declining rate environment enjoyed by investors over the past 30 years.
“We’ve never supported the notions of a traditional glide path,” Edelman says. “Though we acknowledge glide paths can be helpful for saving, we don’t really support the approach used by most TDFs. We think they’re a disaster for the most part because of fatally flawed glide paths.”
Last year, TDFs accounted for more than $850 billion in assets. That figure has ballooned in the 10 years since the Pension Protection Act allowed TDFs to be used as alternative investments within retirement plans. By 2020, financial analysts at Cerulli Associates project that TDFs will capture 90 percent of all 401(k) inflows.
As the eldest groups of TDF holders retire, rising rates threaten the value of their fixed-income allocations, and the managers of these funds can’t always account for the risks that increasing bond allocations carry. Paradoxically, in the current market climate, plan participants might fare better if their TDF falls off its path.
Yet Morningstar claims that when TDFs deviate from their paths to boost returns in response to changing market conditions, it actually costs investors between 11 and 15 basis points a year.
Wandering off the beaten glide path like this can have more dire consequences for plan participants. AllianceBernstein’s 2010 Retirement Strategy Fund notoriously held more than 60 percent of its assets in equities when the financial crisis began in 2008. As a result, the fund saw a 32 percent drop in the fund for the year.
Edelman argues that TDFs have no way of knowing how long the glide path will need to be. The longest-dated TDFs available in retirement plans now target retirements occurring around the year 2060, covering participants who may be 45 years away or more from leaving the workforce.
“It’s not merely that we’re going to live longer; we’re going to be living healthier for longer,” Edelman says. “The notion of retiring at 65 and living to 85 or 95 is woefully antiquated. People are going to be working well into their 70s, [and] are active well into their 80s and 90s. By the time millennials reach retirement, they may be planning for a retirement twice as long as the average retirement is today. They may also have 20 additional years of compound growth that these rules of thumb aren’t accounting for.”