Morningstar’s head of retirement research recently outlined why individuals and advisors should avoid “mixing in” additional investments alongside target date fund (TDF) commitments. Likening it to adding extra eggs to a cake recipe, he emphasized that these improvisations, however well intentioned, invariably alter anticipated outcomes.
What the commentary overlooked is why so many augment TDF investments in the first place. While TDFs haven’t yet had to change given their incumbent status, in today’s digital era — enabling personalization at scale — their relative inflexibility could become conspicuous if the product set doesn’t accommodate the growing demand for customization and transparency.
According to Morningstar’s 2018 Target-Date Fund Landscape report, assets in TDFs eclipsed $1 trillion last year, with fund flows gravitating to newer, passively managed products. The adoption of target-date collective investment trusts has further reduced costs for managers and investors, while open-architecture models and more glide-path optionality have added product breadth. It’s clear that managers aren’t resting on their laurels, even as assets have grown exponentially over the past decade.
Still, while TDFs represented a landmark innovation in the 1990s, advances since have been incremental. Separately managed accounts (SMAs), alternatively, have also accumulated over $1 trillion in assets, featuring a value proposition centered on exclusive customization and breadth across asset classes. As a result, SMAs are particularly appealing to high-net-worth investors seeking an endowment-model approach tailored to their unique circumstances. However, it’s not the model that precludes TDFs from closing the customization gap; it’s the operational complexity.
The growth of TDFs can be attributed to the Pension Protection Act of 2006, which authorized automatic enrollment into 401(k) plans and sanctioned TDFs as a default investment vehicle. This speaks to the value of TDFs amid a larger transition among employers from defined benefit to defined contribution plans. Even as TDFs represent an ideal solution for indifferent investors, RIAs can sometimes be stymied by the lack of customization, at least compared to other alternatives.
In targeting a retirement date, for instance, the five-year increments of TDFs can seem imprecise when considering the Social Security Administration defines retirement ages down to the specific month. Meanwhile, advisors’ risk-tolerance questionnaires may contain as many as 20 questions to categorize clients into one of six risk profiles. The most flexible TDFs, by comparison, may offer two buckets: conservative or aggressive. RIAs who work across a wider demographic band can also struggle when toggling between the capital-preservation bent of wealthier clients, more aggressive styles for lower earners, and everything in between.
TDFs pose other challenges for advisors. In the past, market downturns exposed fund managers trying to goose their performance by tilting allocations to higher risk assets. During upturns, advisors need to continually remind investors about the goal of a diversified portfolio. More recently, though, performance discussions may revolve around sleeve construction and the breadth and depth of assets available.
Consider, for instance, how legacy operators tend to process trades. The manager’s hands are generally tied when market developments — such as unexpected interest rate hikes — would otherwise trigger a portfolio rebalance. The prevailing model, based on tradition versus what’s optimal, favors tying rebalancing to batch-based calendar dates instead of needs-based execution. The ensuing challenges can be overcome, but will require the industry to change to a direct-instruction model. The nature of an omnibus trading environment, utilized by most TDF providers, means trading costs remain relatively flat regardless of the number of times a TDF is rebalanced.
Many advisors also struggle with the transparency challenges. While fees have generally come down thanks to growing passive fund flows, this trend muddies the waters in comparing products and endeavoring not to overpay for passive exposures. Even more challenging for RIAs, given the “set-it-and-forget-it” disposition of TDF investors, are questions about allocations and whether changes stem from performance, progression along the glide path, or manager-driven glide-path adjustments.
But it doesn’t have to be this difficult. The bottlenecks obviating progress are, for the most part, a back- and middle-office issue among managers rather than a structural problem inhibiting change. Most asset managers are effectively deploying a mutual fund chassis for their TDF operations. This is akin to hitching a semi-trailer onto a Prius. Fund managers, as a result, are still reliant on spreadsheets and manual processes that create inefficiencies forestalling product innovation.
The same way product innovation, and robo-advisors in particular, are revolutionizing broker/dealer advice in the smaller account space, it should have a similar impact on TDF product development. For instance, several TDF managers have introduced two-year intervals for the glide path, while others have integrated additional sleeves to invest in international equities, or even sleeves that offer exposure to alternative assets. Each of these innovations will likely be adopted by the mainstream over time to maintain the dominance of the multi-allocation model in retirement plans.
In terms of facilitating customization, technology already exists that can improve sleeve construction and allow for greater diversification and depth across asset categories. The days of three sleeves tied strictly to cash, bonds and stocks should have been retired a long time ago.
Technology will also improve processes to enable more exacting glide paths with increased periodicity, improved “to and through” capabilities, and more alignment to an individual’s objectives and circumstances. Participant portals and improved information flow will also resolve the transparency issues, while digitalization introduces a scalable model that cuts costs and promotes continual product innovation.
That fund flows continue to drive asset levels higher hasn’t reduced the urgency of managers to innovate. Those in the industry are fully aware of competition from robo-advisors, now seeking to mimic the “default” nature of TDFs. One recent entrant, for instance, introduced a paycheck allocator that channels direct deposits toward budgeted expenses and investments. More experienced investors, on the other hand, are piling into SMAs, which have been moving downstream. In some cases SMAs are available to accounts with as little as $100,000.
But as TDFs proved in the 1990s, innovation will always win. The question, however, will come down to who innovates and how the advances allow TDFs to maintain their advantage over other unproven alternatives.
Whitfield Athey is CEO of Delta Data Software. Prior to being named CEO, Whitfield served as chief operating officer from April 2012 to January 2015. Whitfield was head of product strategy and continues to influence that organization both directly and as a member of the executive team. His role at Delta Data is focused on growth of the product base, satisfaction of clients and scalability of the organization.