Target-date funds, revolutionaries of the defined contribution market, are managed as "relics of the past" and in need of sweeping innovation, according to new research from AllianceBernstein.
As the past decade has seen TDFs reach compound in 401(k) menus, their design has become static, reliant on single managers, archaic equity-to-bond portfolio balancing ratios, and little deference to the vital need of income distribution in retirement.
By far the most utilized plan default option, TDFs' failure to keep up with product innovation and the best practices of fiduciaries to pensions and endowments has put defined contribution participants' security at risk, says AllianceBernstein.
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That failure to include innovations such as multi-manager funds, independent fund selection, and the incorporation of alternative options such as liquid or ill-liquid funds-of funds can be explained by the concentration of the TDF market: the largest three providers account for about 75 percent of all TDF assets.
And that has stifled innovation, argues AllianceBernstein.
Though some cash options are offered as workers inch closer to retirement, and a "nod" to nontraditional investments like commodities and real estate are found in some options, the overall lack of diversification has shorted 401(k) participants.
Median returns for the ten-year period ending June 2013 show TDFs, which yielded 6.3 percent, lagged the performance of large endowments, which returned 8.2 percent, and state pensions, which returned 7.2 percent.
"As we see it, traditional glide paths that rely exclusively on traditional stock and bond allocations will be less likely to deliver enough investment growth," according to AB's researchers.
Those lack-luster returns expose participants to increasing inflation and longevity risk, the paper points out.
The next bear market will also expose pre-retirees to interest rate risk, as bonds are already near all-time yield lows, giving them little room to fall, meaning bond returns will struggle provide a cushion to losses in the stock market.
That means glide-path managers need to be looking for other ways to protect near retirees when the next bear market hits, according to the paper.
The largest defined contribution plans have begun to revolutionize the proprietary TDFs designed for their participants, says AB. That often means incorporating a range of alternatives.
"For some investors, alternatives carry an undeserved stigma of outsize risk, but nontraditional investments are helpful in a comprehensive, long-horizon retirement investment," according to the paper.
"They help reduce risk and generate return, which is important, given the more challenging return environment expected over the next couple of decades. In the recent past, the enhanced use of diversifying asset classes has been highlighted as a key reason that both large endowments and state pension plans outperformed target-date funds."
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Nick Thornton
Nick Thornton is a financial writer covering retirement and health care issues for BenefitsPRO and ALM Media. He greatly enjoys learning from the vast minds in the legal, academic, advisory and money management communities when covering the retirement space. He's also written on international marketing trends, financial institution risk management, defense and energy issues, the restaurant industry in New York City, surfing, cigars, rum, travel, and fishing. When not writing, he's pushing into some land or water.
