Target-date funds: More 'path' than 'glide' and desperately in need of a rethink

Target-date funds, or TDFs, were initially created to work something like time-lapse photography. Let’s say you want to capture a tree’s growth to maturity. Individual snapshots are automatically taken at set intervals over a long period of time.  You forget about it until things come to full fruition, then lo and behold, you can play back the series of shots in rapid succession to see a sapling grow into an oak, as if 30 years were 30 seconds. Similarly, TDFs come with a promise to grow an investor’s assets over time by updating “snapshots” of stock-to-bond asset allocations without the investor having to do anything. As the investor grows older, TDFs automatically rebalance away from risky equities and towards safer fixed income assets. This culminates at retirement with a portfolio that is balanced to provide retirement income without taking too much risk.

Unfortunately, the realities of today’s market mean that we can no longer take for granted the oak’s undisturbed path to maturity. The ‘one and done’ concept of TDFs, the premise that a fund would keep growing as an investor moves toward retirement, passively continuing to contribute, is a threatened species. Let’s take a closer look.

What are TDFs, and why are they at risk?

TDFs came into being under the Pension Protection Act of 2006, which paved the way for them to act as qualified default investment options in retirement plans. TDFs offered convenience as well: they came in chassis separated by five-year increments, allowing investors to pick a target retirement date, select that corresponding TDF, and forget it.

But at that time, the industry was still operating under old stock-to-bond asset allocation assumptions that were starting to break down as yields on fixed income assets continued a decades long decline. Add to that, less than two years later came the financial crisis and housing catastrophe. This led to the Federal Government pulling many levers in both fiscal and monetary policy, with quantitative easing as the end game. The result of that period has been historically low interest rates. What this means, simply put, is that the sapling is going to need a lot more active help to grow into that oak. 

Where fixed income investments—usually bonds—had traditionally been the defensive element in a portfolio, those low interest rates now place them in the category of high-risk investments—in some ways riskier than equities. Bonds are now yielding near zero percent—and there’s a salient argument to be made that, factoring in inflation, the net real yield on some of today’s more popular fixed income proxies is actually negative.  This has resulted in a much different glidepath than those theindustry presented to Congress when it lobbied for the opportunity to sell qualified default fund solutions.

This places a burden on American workers, who were once able to put their money in safe assets and worry very little about the drawdown of their value, while at the same time still enjoying some appreciable benefit in the form of real return, and in some instances real income that could be earmarked for retirement. 

The fallout from the current state of interest rates and looming inflation is such that the same comfort level in long-term, fixed income type investing has ceased to exist. And—bad news—we’re not forecasting that it will return to any sense of historical normal in our working lifetime.

But there may be some new ways of thinking about the problem.

Not all TDFs are created equal

The classic investment portfolio construction is a 60/40 stock-to-bond asset allocation, serving as the main proxy for a moderate investor halfway through their investment journey. This model serves as the foundation for everything having to do with glide paths as they apply to target-date funds (TDFs).

But TDFs and glide paths were designed at a time when the rules were shifting for the 40 percent fixed income segment of that classically conceived portfolio. And now they are shifting again—radically. 

From the perspective of the plan sponsor and the participant, there is a common misconception that all glide paths are the same, and therefore all TDFs are the same. However, there’s nothing in the statute that requires TDFs to be arranged in groups of ten, or that they must be created around a five-year chassis.  Conversely, not all funds with the same date in their name are equal—in fact, that is seldom the case. The manner in which the products in the portfolio are arranged varies considerably from one fund company to another.

Another more general misconception that affects the retirement investor is the static set of assumptions that all 50-year-olds are in the same situation or have the same needs. As an advisor I’ve never found this to be the case in reality. And if you think about various people you’ve known at 50, you too will likely come up with many different scenarios in terms of their health, assets, financial literacy, attitude, and outlook on the remainder of their lives. From the investment advisory side, we see this manifest in different rates of deferral, risk preferences, and so on.

A solution: Customization within the glide path

What can we do to help those people who have worked hard every day to amass enough to provide a meaningful and solvent retirement experience? How can we make sure their investment doesn’t disappear into the zero or negative interest rate ether?  

We need to start with the end in mind—our goal is retirees’ dignity and solvency, addressing sequence of return risk and longevity risk. Then, working backwards, how might we design glide paths today to achieve this outcome?

First, advisors and employers need to recognize now that we are a long way away from the desired outcome of getting employees successfully to retirement. Most of us are still in denial about that. Second, it’s urgent that plan sponsors get actively involved in evaluating TDFs and other glide paths for their employees, understanding that employees are individuals and do not all fall under the same category. Therefore, some customization and individualization will be called for in their approach to employees’ retirement paths. Third, educating the consumer—in this case, the plan holders—on the differences and concerns we’ve discussed here is important—their voice will allow a plan sponsor to ask intelligent questions and try to find the right mix for their employees.

Some helpful questions include:  How might you address customization for my employees?  How might you solve for my desire for less risky assets while overcoming the abysmally low interest rates it seems we’ll be saddled with for the next 30+ years? Those types of questions from the consumer—often initiated by the employer—are going to help encourage competitive and innovative action.

Now the industry needs to take bold action

Then it’s time for the investment industry to roll up its sleeves and solve the problem through innovation and competition—all we have to do is look to the competitive, innovative approaches to the recent space shots by Richard Branson and Jeff Bezos to see how much can be learned from this: there are many ways to reach your end goal. 

Considering the current market, a retirement solution would seem to call for a healthy exposure to equities—this of course holds lots of upside potential, but also exposes workers who are within ten years or less of retirement to extreme event-driven volatility. With interest rates so low, we realize it would be foolhardy to be overexposed to fixed income assets that have a low or net negative return. But where is the middle ground? We’re working on one answer to that question, and we acknowledge that there are several other answers currently in the works. But the key message is that as an industry, we need to get our heads out of the sand and take bold action.

Our elected officials can help in this. Because employers and advisors are so fearful of litigation, we need Congress to be clearer about ways employers can absolve themselves of fiduciary risk while seeking innovation solutions. ERISA lays out a prudent person standard of care, but prudency has been broadly implemented through backwards looking processes.  We fixate on past performance instead of asking whether the old art is sustainable for a modern low interest rate era.

Albert Einstein is credited with saying, ““The definition of insanity is doing the same thing over and over again but expecting different results.” Sadly, this is where we are with our 15-year financial experiment in glide paths and target-date funds. As an industry, we should be asking ourselves, isn’t it time to explore a different approach—one that will help the American worker achieve a dignified retirement?

John Ruth is co-founder and CEO of Build Asset Management, an asset management firm specializing in strategies focused on fixed income and options.