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.