Are TDFs shorting retirement investors?

Are retirement investors in the $1.1 trillion target-date fund market being shorted by a lack of exposure to alternative investments?

A new paper from Georgetown’s Center for Retirement Initiatives suggests they are, and sets out to quantify just how much savers are potentially losing by investing in products that mostly split risk between equity and fixed-income exposure.

Only eight of the 41 TDF managers tracked by Morningstar include alternative investments like private equity, hedge funds, and real estate, according to the 2018 Target-Date Fund Landscape Report. One fund’s series pulled its alternative exposure due to lack of demand.

That relative dearth of access is hurting TDF investors, argue analysts at the CRI, which teamed with Willis Towers Watson’s defined contribution advisory team to author “The Evolution of Target Date Funds: Using Alternatives to Improve Retirement Plan Outcomes.”

Plan sponsors’ “myopic” focus on fees in an era of common 401(k) litigation, alternatives’ illiquidity relative to equity and bond securities, and TDF managers’ lack of in-house expertise with alternatives have conspired against their use in TDFs, the paper says.

“For the most part industry-wide usage of alternatives has been very limited because those asset managers do not have the internal expertise with alternatives. Therefore, if a sponsor wants to add exposure to alternatives today, building custom funds is the most effective approach,” according to the paper.

How private equity fared

To test what participants may be missing from garden-variety TDFs, the analysts plugged alternative strategies into a baseline glide path based off 21 fund families.

To test the potential value of private equity, analysts replaced 10 percent of the baseline glide path’s equity allocation with private equity. A hypothetical full-career employee saw their retirement income increase with conservative and moderate private equity weights.

For those with the most savings, private equity increased annual retirement income by more than $11,000 when accounting for a moderate private equity allocation—which the research defines as 20 percent at the beginning of the baseline glide path, tapers to 10 percent at retirement, and ultimately to 0 percent 10 years after retirement.

Core real estate

While private equity seeks to outperform public equities, real estate investments are intended to diversify portfolios and provide downside protection.

In the paper, analysts replace portions of the baseline glide path with conservative and moderate allocations of real estate: 5 percent trending to 0 percent at retirement for the conservative model, and 10 percent trending to 5 percent at and through retirement for what the analysts call the moderate allocation model.

Over the long term, hypothetical savers reduced risk on the lower end of the savers’ spectrum for modest losses seen with savers with higher account balances.

“Unlike more opportunistic implementations, core real estate is expected to provide lower returns with significantly lower volatility than traditional growth assets,” the paper says.

How hedge funds fared

To test hedge funds, the analysts implemented a conservative strategy that starts at 10 percent of the baseline TDF’s total allocation and draws down to 5 percent at retirement, and what the analysts call a moderate strategy, which begins with a 20 percent allocation that draws down to 15 percent at retirement. Hedge fund assets are drawn from the baseline TDF’s equity and fixed income positions.

Income replacement rates were improved using both the conservative and moderate allocation models across all income levels, but at lower levels than was seen with private equity. Only the returns of “high-skill, high-conviction” hedge fund managers were modeled in order to account for the wide discrepancy between the best-performing and average managers.

What happens when you use all three

To see how a TDF with the full arsenal of alternatives performed, analysts compared the baseline glide path, which begins with 91 percent equity exposure and tapers to 45 percent at retirement, to a glide path that includes private equity, real estate, and hedge funds along the way, that begins with 97 percent of a portfolio committed to return-seeking assets and tapers to 63 percent at retirement.

While the alternative-laden glide path appears riskier, the paper notes that it holds only 33 percent in public equity assets, versus 42 percent in the baseline glide path.

The alternative model resulted in good to exceptional outcomes, based on the modeling in Georgetown and WTW’s paper.

In the best-case scenario, a fully diversified TDF generates almost $94,000 in retirement income for every $100,000 in annual income earned before retirement.

By comparison, the baseline TDF approach generates $77,000 in retirement income per $100,000 in annual wages under the best-case scenario.

In the median outcome, a hypothetical saver would have more than $9,000 in retirement income using a fully diversified strategy compared to the baseline strategy. And in the worst-case scenario, weaving alternatives into glide paths improves retirement income by $2,300 annually, from $21,200 in the baseline TDF strategy to $23,500 in the diversified strategy, assuming the paper’s modeling.

“The increased diversification provides risk benefits over time versus the baseline,” claim the paper’s authors. “While diversification is utilized marginally in the products offered today, there is still a lot of room to enhance DC participant outcomes through greater usage of alternative investments.”