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.”

TDFs are popular because they offer instant diversification in stocks, bonds and cash-like investments, but their potential returns may be sandbagged by their failure to allocate to real estate, natural resources, commodities and precious metals, and other alternatives, says Rich Lang, multi-asset investment director at Capital Group.

Until recently, TDFs have also tended to place participants in portfolios constructed from record keepers’ proprietary funds, at times in high-fee share classes, notes Andrew Arnott, the CEO of John Hancock Investments.

For many advisors, the biggest problem with TDFs remains cost: Since a target-date series imposes its own management costs on top of a fund’s existing fees, expense ratios at times top 120 basis points—and high-cost TDFs may run afoul of existing ERISA fiduciary requirements.

Asset managers are heeding the call for better, lower cost target-date products. In November 2015, Dimensional Fund Advisors unveiled a TDF series that tilts toward inflation-protected Treasurys as investors near retirement. The hope is that these will provide a buffer against market volatility and inflation.

In 2016, BlackRock shifted its actively managed TDF series to smart beta mutual funds whose allocations are 80 to 90 percent low-cost ETFs. Toward the end of the year, Schwab debuted the lowest cost target-date series on the market, which charges 8 basis points in expenses.

Some advisors working with larger 401(k)s are embracing customized or “open architecture” TDF options, according to analysis published in February by Cogent Reports. According to the study, roughly 15 percent of advisors managing at least $50 million in defined contribution plan assets are using some type of custom TDF.

In open architecture TDFs, plan advisors have the freedom to select any fund available on a platform for inclusion in a target-date strategy and implement that fund within a glide path.

“Open architecture is potentially a better strategy because there are some managers out there that are great single managers within TDFs, but there are certain risks that come into the equation that may be alien to them,” Arnott says. “A manager or a firm can’t really be all things to all people; it’s very rare that you find one that is good at a lot of different things, across asset classes.”

In 2016, OppenheimerFunds launched the (k)ustom Advisor Program to help advisors vet “semi-custom” target-date funds. While custom TDFs allow advisors and sponsors to control the glide path and fund selection within funds, semi-custom plans offer advisors the ability to select investments and adjust allocations within an established framework.

“Our semi-custom TDF plan uses a custom model playbook,” says Kathleen Beichert, OppenheimerFunds’ head of retirement. “We keep it flexible. When working with a sponsor, advisors usually decide on a target-date strategy first—who has the best glide paths, who has the best funds. In (k)ustom Advisor, we can come in and help advisors understand which platforms have the options they want.”

Rather than choosing a target-date strategy based on fund selection, (k)ustom Advisor helps sponsors evaluate plan participant demographics, assess the platform capabilities of record keepers and third-party providers, develop a custom implementation road map for a TDF series and manage the fiduciary oversight.

According to Beichert, innovative target-date strategies like custom TDFs can help advisors differentiate themselves to sponsors and participants. In custom TDFs, fiduciaries can tailor a glide path and a fund lineup to suit specific situations.

“Employees aren’t exiting plans in the same way—some retire and take distributions, some take a lump sum when they leave,” Beichert says. “They aren’t all the same. Some receive stock options, and thus a TDF wouldn’t need as much of an equity exposure. Others still have a defined benefit plan, thus a TDF wouldn’t need as much of a fixed-income exposure. Advisors need to account for the variability.”

The DOL appears to be open to the use of custom target-date series to help sponsors tailor a better solution to their participants’ needs, says Arnott, because the funds are potentially better at meeting an individual participant’s needs.

“We’re starting to see more interest in customizable or multi-manager options because of the heightened requirements and awareness around fiduciary responsibility,” says Arnott.

American Funds, which also functions as a record keeper, is keeping its proprietary funds within TDFs, but using its broad mutual fund lineup to create a more customized asset allocation for plan participants—instead of shifting among asset classes, American Funds also shifts within asset classes as the target date approaches.

Lang describes the process as a dynamic glide path—so as a participant’s equity allocation decreases, the nature of the exposure shifts toward higher-dividend-yield, lower-volatility products. American Funds’ TDFs carry expenses ranging from 35 basis points for a 2010 TDF to 46 basis points for a 2060 fund.

Lang argues that open architecture and “custom” target-date products carry their own risks.

“Not only open architecture TDFs, but ‘custom’ ETFs seem to be getting more attention,” says Lang. “I would warn that best-in-class funds across asset classes won’t always create the best portfolios. It can help to have managers who are familiar with all the underlying building blocks of a TDF.”

John Hancock offers series of multi-manager ETFs. The asset manager has used a multi-manager fund-of-funds approach in target-risk funds since the late 1980s, so when TDFs came along, the firm took the same tack. Now the firm has $100 billion in TDF assets across three target-date series managed by 175 investment professionals.

“We see our funds not as open architecture, but managed architecture,” says Arnott. “The reality is that inside our TDFs, not every manager in the universe is available, but it’s a broad set of about 30 managers. It’s one thing to get a glide path and an allocation correct; it’s more difficult to make sure that we have the right managers in the mix.”