With the popularity of target date funds swelling assets to more than $763 billion at the end of 2015, defined contribution plan sponsors now have a sea of choices. But many are still trying to navigate the target date fund landscape based on common myths, which could steer them off course from their participants’ best interests. It’s time to dispel the myths and get back to what we think matters most based on participant time horizons and risk profile – asset allocation and robust risk management.
Myth 1: Target date funds that are passively managed have less risk.
The move to passive management, driven in large part by fee pressure, is undeniable. And, 50% of plan sponsors surveyed in the 2015 MFS DC Investment Trends Study think that passively managed funds have less risk than their active counterparts. But here are two problems: First, passively managed funds take the same risk as the market and often concentrate on stocks that become overvalued. Second, there is actually no such thing as a passively managed target date fund.
While some target date funds invest exclusively in passive funds, the fund managers still make active decisions with respect to asset class allocation, underlying fund selection, glide path design, portfolio rebalancing and risk management. On the latter, recent volatility reminds us just how important those active management decisions can be, particularly with respect to strong risk management.
Myth 2: Target date funds managed tactically can avoid market downturns.
The truth is, not many target date funds take this approach because adding value consistently through tactical asset allocation is not easy. In fact, target date fund managers have few opportunities to make market or asset class calls, because they are constrained to making decisions based on the underlying funds.
Here’s the concern: tactical investing done in a material way can change a fund’s risk profile. That happens inadvertently to funds that fail to rebalance after relative market performance causes deviations in the funds’ asset classes or underlying fund weights. Allowing the markets to dictate a fund’s tactical asset allocation this way can be dangerous – with potentially negative surprises for investors expecting a very different risk profile.
Myth 3: Target date fund glidepaths can be built based on the “average” participant.
Constructing a glide path that is optimal for a representative participant, is by definition sub-optimal for everyone but that participant. It’s like being a shoe manufacturer who makes only size nine shoes because that’s the average. The trouble is, the shoes don’t fit most of the population.
Glidepaths by design are meant to accommodate a wide range of investors. So, the discussion shouldn’t really be about “to” or “through” glidepaths or a one-size-fits-all participant profile, given how dramatically demographics vary from plan to plan. Instead, we need to make the right asset allocation decisions for the end investor. That means building a portfolio that properly balances capital appreciation against principle preservation in relation to the time to the target date. We believe glidepaths should reflect a high level of risk tolerance early on and a high level of risk aversion as the target date approaches. Studies show that 80% of participants take their money out of the plan within three years of retirement. So, a glide path that reaches its final resting spot 15 years past that target date creates a very aggressive “to” portfolio for investors who leave the fund right at or shortly after retirement.
Myth 4: You can judge a target date fund manager’s skill based on shorter track records.
Target date funds are by their very nature long term investments and investors seem to get that. A recent report from Morningstar called “Encouraging signs for target-date funds” suggested that target date fund investors might be more patient than other fund investors. As evidence, they pointed to target date fund investor results that were 74 basis points higher than their funds’ total returns, compared to the negative return gaps experienced by other fund investors who trade in and out. So, if investors are more willing to stay the course long-term in a target date fund, why are more than 50% plan sponsors looking at three-year track records, as we found in a recent study(iv)? To get a more complete picture, see how a target date fund has performed peak to peak or trough to trough – through a full market cycle.
Myth 5: Risk management is an afterthought.
When it comes to long-term outperformance, minimizing losses on the downside is just as important as capturing the upside. Many target date fund investors found that out the hard way after the global financial crisis. The fact is, there is greater persistence in risk than in return. So if you get the risk side of the equation right, you can manage a target date fund’s risk profile more effectively through time. That takes a sound investment process where risk management is baked in at every level.
As target date funds continue to evolve and grow in popularity, it’s easy to lose sight of the features that align best with participant needs. We believe putting a priority on active risk management and asset allocation will help plan sponsors make choices managed for their participants’ long-term horizons.
Ryan Mullen is MFS Senior Managing Director, Head of Defined Contribution Investments.
