Do target date funds 'exploit' investors? Retirement scholars say 'no'

Target date funds have grown quickly since coming on the scene almost three decades ago. The multitrillion-dollar industry came under Congressional scrutiny recently when the Senate Committee on Health, Education, Labor and Pensions asked the Government Accountability Office to review these funds.

Many see this type of review as important,as TDFs have become a common default investment in defined contribution plans. Critics worry that their strategies, which tend toward “set it and forget it,” could underperform, or that there is too much risk in these funds as participants get closer to retirement.

Still others say the funds hold too few equities later in retirement, putting investors at risk of going broke.

Yet support for these funds among retirement experts is strong. For example, Christine Benz, director of personal finance for Morningstar, included in a column three reasons these funds are important: They allow investors to be hands-off, they provide cost-effective advice and they contribute to a good outcome.

But a recent study, The Unintended Consequences of Investing for the Long Run: Evidence from Target Date Funds by finance professors Massimo Massa, Rabih Moussawi and Andrei Simonov, caused some controversy.

“We document that asset managers exploit the lower investor attention to deliver lower performance,” the authors wrote in the abstract of the study, published on SSRN.

In an email, Andrei Simonov, responding for the group, said they believed TDFs are valuable financial instruments, but “we do see the problem with closed architecture, excessive use of actively managed funds (mostly not of the higher quality), and lack of clarity in glide path (and correspondingly, benchmarking troubles).”

We asked several retirement experts their opinions on TDFs and the Massa study: David Blanchett, who is managing director and head of retirement research at QMA, the quantitative equity and multi-asset solutions specialist of PGIM, and Michael Finke, professor of wealth management at The American College of Financial Services.

We also asked Ted Benna, known as the “Father of the 401(k),” for his thoughts on these products as well. And we also asked the study authors to respond to their comments.

Finke said the controversy on TDFs surprised him because “most retirement economists view the use of [TDFs] as qualified default investments one of the most successful policy changes that resulted from the Pension Protection Act of 2006. It defaulted workers into a diversified, low-cost, age-appropriate, automatically rebalancing investment portfolio that was light-years better than money market defaults pre-2006 and the funds workers chose on their own.”

Blanchett said TDFs were “an excellent way for many investors, especially those participating in a 401(k) plan, to delegate investment management to a professional. My concern is the lack of personalization.”

The biggest problem with TDFs, Finke concurred, was “they are a one-size-fits-all solution. This makes them cheap and a good choice for most workers … [but] I see a new generation of solutions that provide both a degree of personalization and automated, low-cost investing.”

Do TDFs lack investment oversight?

The Massa study found TDFs lacking in several areas. One was that “given the investor’s relative inattention, the fund manager finds himself in the privileged position of investing in the long run without the investor’s short-term scrutiny.”

Blanchett and Finke disagreed.

“You have the plan sponsor. You have a professional, a typically institutional fiduciary who is responsible for the review,” Blanchett told BenefitsPRO’s sister site ThinkAdvisor.

“Almost all [TDF] assets [are in] in defined contribution plans. … It’s true that the individual investors likely are not involved in the decision to pick the TDF, but someone else is. Fiduciary, by definition, is responsible for ensuring that the funds are appropriate.”

Finke agreed, writing in an email response: “The Massa study pointed out that just because many of the largest TDFs are cheap and efficient, others are not as efficient and there is potential for abuse. Why? A set-it-and-forget-it investment is by definition not an investment that is closely monitored, and firms can take advantage of the lack of oversight by throwing less competitive investments in the mix. Of course, there are fiduciary pressures to limit abusive practices.”

Simonov said in response that “if the fiduciaries do their job, then after the 2008 scandal, TDFs would not repeat the same mistake (drastic underperformance for TDFs close to retirement). And they did (in 2020). As a reminder for your readers, the target-date controversy began in February 2009 when an investigation by the US Senate Special Committee on Aging found that, among funds designed for people planning to retire in 2010, there was ‘a wide variety of objectives, portfolio composition, and risk.’”

Performance questions

The study concluded that TDFs “deliver lower performance than other comparable U.S. equity funds” and that “TDF performance is worse the further the TDF is from its maturity date.”

Simonov added in his note that the underperformance they illustrate in the paper “is probably due to the absence of a clear benchmark and difficulties pension plan sponsors have in assessing the performance of TDFs. Our results suggest that the underperformance is more pronounced for the target date fund within the same target-date fund series with the longer horizons (so, taking the same family and comparing 2020 fund vs. 2065 fund).”

The professors found “a cumulative return loss of 21% for an average investor holding the fund for 50 years.”

Finke said: “One important point about focusing on performance rather than expenses is that we’ve just had the longest bull market in U.S. history, and any fund that had a more risky glidepath with a higher stock allocation outperformed during this period.

“This also has the perverse incentive of rewarding funds that may have had a riskier allocation than employees would have preferred, so nobody should be looking at relative performance when evaluating the benefits of TDFs. We shouldn’t be punishing funds that have a more conservative glidepath, because default investors tend to be less financially sophisticated and more risk-averse.”

Blanchett noted that “TDFs are significantly less expensive than the average mutual fund. Based upon that fact alone, the idea that TDFs underperform an appropriate benchmark of other more expensive active funds doesn’t make a whole lot of sense.”

Simonov stated that “Frankly, we do not think that this explanation holds any water. First, our results hold both net and gross of fees. So, even before the fees are taken out, TDFs underperform.”

What about fees?

The study also noted that there were two layers of fees charged to TDF investors: “the fee TDFs themselves charge and the fees by the underlying funds in the TDF portfolios.”

But Blanchett disagrees: “There [are] not two layers of fees. That is absurd. I read [the study], and I’m like, these guys don’t understand how TDFs work. There are very few, if any, major TDF providers that charge an additional fee beyond the underlying fees. Some do, but virtually none of the largest providers do that, because they’re using their proprietary investments.”

Simonov responded: “According to our data and to a recent Morningstar study, many funds have this two-layer fee structure. Even for funds with zero fee on the TDF wrapper (e.g. Vanguard Target date fund series), the effect of fees is stronger because Vanguard choose the more expensive share class for their TDFs.”

The study stated that there should be “an open-architecture structure at the fund level,” meaning these funds should expand beyond the issuer’s family of funds.

On this, Blanchett agreed: “I like the idea of open architecture. I like the idea [of] utilizing money managers, different companies. I’m not sure I believe [a company] has the very best managers across all the different asset classes. And I do like the idea of having access to a variety of fund families. In theory, there would be a benefit to doing that versus having, you know, a single fund family investment. That being said, it’s not clear how much benefit that would add.”

And of course, he said, that could add another layer of fees.

Benna’s perspective

Benna provided a history lesson on TDFs as well as a warning. He explained that he helped create the TDF market, and concluded that Fidelity’s “Freedom Funds provided a better alternative. Participants could invest directly in an age-appropriate portfolio without having to answer a bunch of questions. Rebalancing also occurred automatically, and risks were reduced as an investor grew older.

“I started to push for broader utilization of these funds. I was initially told by the major mutual fund companies this wasn’t necessary, that they tried lifestyle funds and they didn’t work well. Fund companies other than Fidelity began to create their own funds as the market demand increased.

“My biggest issue is that the recordkeepers permit participants to treat TDFs as if they are just another fund option. They weren’t willing to spend the money to modify their systems so that participants who invest in a TDF are limited to just the TDF.

“I mentioned this to the head of Schwab’s retirement business when he asked me to endorse their TDFs. I told him I wouldn’t do that unless they changed their recordkeeping system to keep participants from treating the TDFs like the other funds offered by a 401(k). He said they would deal with that via education, which hasn’t worked very well.

“Many TDF investors don’t understand the investment risk; therefore, there will be a huge outcry when the next 2008 comes. This will happen even though the losses that occur will be similar to those that occur with other similar portfolios including managed accounts.”