Oversimplification in Target Date Funds Part II
Last month we featured Part I of Oversimplification in Target Date Funds Endangers Participants’ Retirement Savings - How are custom solutions evolving to mitigate risk? Part I introduced version 1.0 of target date funds, now learn about version 1.0’s evolution to version 2.0, that sets the stage for version 3.0, which we will end with next month.< Version 2.0: Introducing New Choices
As the single-manager and single-glidepath risks of version 1.0 have become more evident in the marketplace, recordkeepers have stepped up, devising solutions to help plan sponsors address these issues. This leads to TDF version 2.0, a recordkeeper solution that is customized by the plan sponsor. This approach allows plan sponsors to develop a glidepath best suited for their plan’s demographics, while utilizing the underlying managers already in place. In version 2.0, plan sponsors diversify their participants’ assets across a variety of investment managers, on a glidepath better suited for their participant population rather than an off-the-shelf version designed for the median or average participant. Version 2.0 glidepaths generally are a function of a plan’s demographics, not the entire universe of defined contribution investors, which is one benefit of moving from a version 1.0 to a version 2.0 TDF, because version 2.0 allows fiduciaries to better identify a glidepath for their participants.
Version 2.0 Provides Flexibility to Choose a More Appropriate Glidepath
According to our TDF categorization/analysis, 50 percent of version 1.0 TDF providers offer aggressive glidepaths. This means that half of the proprietary version 1.0 providers have allocations that favor equities and risk-based assets not only during the accumulation phase but also near, at and sometimes even through retirement. With approximately 50 percent of version 1.0 TDF providers offering this aggressive solution, the challenge for plan sponsors is selecting something other than an aggressive option if what their participant population really needs is a more moderate or conservative solution. Early on, the recordkeeper constraints on TDF providers exacerbated this problem, only to be loosened somewhat over the years.
The aggressive TDF solution is still the most utilized glidepath today. This is supported by the wide body of evidence suggesting participants do not save enough for retirement. An aggressive glidepath may act as the most appropriate “catchall” for the average participant because most will need more return from their investments to make up for the general lack of retirement savings. It is no coincidence that the top three proprietary version 1.0 providers, Vanguard, T. Rowe Price and Fidelity, all run aggressive glidepaths.
For plans, however, where participant savings rates are high and/or employer contributions are generous, the landscape becomes challenging when identifying an appropriate moderate or conservative glidepath. The more conservative the plan sponsor becomes or the demographics suggest, the options dwindle and very few solutions exist. Version 2.0 allows a plan sponsor to address this, accommodating a less risky glidepath that may be more appropriate for their participants.
Manager Options in Version 2.0
At the same time the glidepath is addressed, version 2.0 allows the plan sponsor to address the managers utilized within the TDF strategy. So, while in version 2.0 a plan sponsor is not tied to an aggressive glidepath, a plan sponsor is also not tied to a single investment manager. For example, there may be an index fund that better replicates a desired index than the index fund currently being used. A plan sponsor can allocate among other types of funds or investment managers, including some strong active managers. It is not an either/or proposition.
Version 2.0 Creates Three New Problems—No Historical Performance, No Fact Sheets, and No Portability Across Recordkeepers
While version 2.0 solves some problems of version 1.0, it unfortunately also introduces three new problems. First, model portfolios do not carry historical performance, so participants cannot reference how the glidepath, or asset allocation, performed over time. Second, typically there are no fact sheets related to the models, meaning there is a lack of education and information for participants. Third, models are recordkeeper-dependent. If the plan sponsor has a recordkeeper that cannot support the model, it requires moving to an entirely new recordkeeping platform. As the plan grows, other options can be affected if the plan were to leave for another recordkeeper for fiduciary reasons. New models would again have to be built on the new platform, subject to the rules and constraints of that new platform. Therefore, the models may not look or act exactly like they did on the old recordkeeping platform.
Over the past ten years, version 2.0 has been available to plan sponsors, but despite its benefits, these three primary problems have limited the adoption of version 2.0 by plan sponsors.
This is an excerpt of flexPATH Strategies’ white paper, Oversimplification in Target Date Funds Endangers Participants’ Retirement Savings - How are custom solutions evolving to mitigate risk? Next month we will release the final part of our series, Part III of the white paper, and introduce version 3.0 of target date funds. To view the white paper in its entirety, please click here.