Target date funds: Plan sponsors adopting the lower-cost options for long-term investments

Coming off of a record high in 2021, target date assets fell 14% to $2.82 trillion in 2022 driven by market depreciation, according to Morningstar’s recent Target-Date Strategy Landscape Report. TDF assets were $3.27 billion in 2021.

Net inflows into target-data strategies of $153 billion last year, however, indicate investment stability, Morningstar said.

“Despite last year’s market turbulence, target-date strategies saw considerable inflows, especially into collective investment trusts,” said Megan Pacholok, senior manager and research analyst at Morningstar. “To see target-date investors largely stay the course through the down market is a sign that these strategies are being used as intended — as long-term investments.”

Of the net inflows, $121 billion, or 79%, went into collective investment trusts (CITs), which are tax-exempt, pooled investment vehicles maintained by a bank or trust company exclusively for qualified plans, including 401(k)s, and certain types of government plans. CITs and mutual funds account for 47% of all target-date strategy assets as of year-end 2022, said Morningstar.

Morningstar predicts CITs are on pace to overtake mutual funds as the most popular target-date vehicle in the next two years. Pacholok said plan sponsors continue to show a strong preference for lower-cost target date strategies, which favors CITs that often come at a lower cost. Because they are regulated differently than mutual funds, CITs don’t have to be as transparent in their disclosures as mutual funds, which gives them more wiggle room on price, she said.

The two cheapest quintiles of target-date share classes amassed $60 billion in 2022, and the three most expensive quintiles posted $28.5 billion in outflows, the report said.

Vanguard Target Retirement had the most net new money in 2022 when accounting for both mutual fund and CIT flows; 51% of Vanguard’s target-date assets were in CITs, surpassing the mutual fund version in assets for the first time, said Morningstar.

As the fastest-growing and largest category of investment options held by qualified plans, target date funds have come under increasing scrutiny. A Supreme Court decision last year ruled that fiduciaries have an ongoing duty to monitor the prudence of investment options, including TDFs, in a 401(k) plan and not “select it and forget it,” as they are overwhelmingly marketed to participants.

Related: With target date funds facing scrutiny, where do plan sponsors go from here?

While TDFs have historically faced litigation around excessive fees, Pacholok noted last year saw an uptick in litigation related to the performance of TDFs.

“We haven’t seen one succeed yet, so I think it will be a matter of waiting to see the results of outstanding lawsuits and see how the rulings go to see if there will be more opportunities for lawsuits like these,” said Pacholok.

The lawsuits compared series to a small peer group of the best performers, which could potentially lead plan sponsors into performance-chasing and premature target-date strategy swapping to potentially avoid litigation, Morningstar said. Plan sponsors would be wise to focus on the fiduciary guidelines that are available, and continue to select options that are best for the employees in their plans while remaining cognizant that the historical performance of TDFs doesn’t guarantee future results, Pacholok said.

Finally, Morningstar’s report noted that the opportunity for environmental, social, and governance (ESG) target-date series has broadened, as the Department of Labor modified its guidance to allow ESG-focused strategies to serve as a qualified default investment option.

Four target-date series retained their gold ratings from Morningstar over the past year, indicating they are top options for investors searching for a TDF. These include American Funds Target Date Retirement, T. Rowe Price Retirement, BlackRock LifePath Index and Pimco RealPath Blend.

Kristen Beckman is a freelance writer based in Colorado. She previously was a writer and editor for ALM’s Retirement Advisor magazine and LifeHealthPro online channel.