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Morningstar's Retirement Whiz Warns Against Misusing Target Date Funds

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Target date funds are designed to be the default investment in defined contribution plans. Still, many participants combine them with other investments. Turns out these investors — especially older ones — have more aggressive portfolios versus participants who stick to the pre-selected fund only.

In an interview with ThinkAdvisor, David Blanchett, head of retirement research for Morningstar Investment Management and clearly no fan of TDF mixed investing, discusses the issue and his working paper about it, which he subtitled “Is There a Method to the Madness?

Most of the more than $1.7 trillion in TDFs (as reported in Morningstar’s 2019 Target-Date Fund Landscape) are in passive funds. But, argues Blanchett in the interview, “there is no such thing as a truly passive target date fund.”

Winner of best-research paper awards from the Certified Financial Planner Board of Standards and the Academy of Financial Services, among others, Blanchett, for his mixed TDF paper, studied the allocation decisions of 30,516 mixed target date fund investors to see the characteristics of people who are more susceptible to mixing TDFs and how they mix them.

These investors, he found, build portfolios with allocations that make them more aggressive, “overwhelmingly” combining the TDF with equity funds. Indeed, the mixed TDF investors, on average, have a 49% exposure to equity funds, he writes.

In the interview, the adjunct professor of wealth management at The American College talks about the biggest pitfall to TDFs and offers his long-term forecast for the so-called one-for-all investment.

ThinkAdvisor recently interviewed Blanchett, who was on the phone from his office in Lexington, Kentucky. Before joining Morningstar, the Ph.D. was director of consulting and investment research for the Retirement Plan Consulting Group at Unified Trust Co.

Here are highlights of our conversation:

THINKADVISOR: What’s the biggest pitfall to investing in target date funds?

DAVID BLANCHETT: TDFs are definitely an improvement over self-direction, but the biggest problem is that they lack personalization: You’re lumped into a single allocation. Typically, you get a relatively high-quality diversified portfolio, but it’s not necessarily based on [personalization].

Please discuss your working white paper, “Mixed Target-Date Fund Investors — Is There a Method to the Madness?”

I don’t like mixed TDF investing. TDFs exist to be single investment products, and the goal is to put all your money there. The minute you start combining it with [say] cash [or] emerging markets, you’re creating a self-directed investment. For the most part, mixing makes you a more aggressive investor. If you think that a 20%/30% [exposure] is quote-unquote too conservative, then buy the 20%/60% fund.

How can financial advisors help with TDF investing ?

If you have a financial advisor, they can help you figure out the right portfolio for you — that’s the job of the advisor. The optimal strategy for [401(k) plan] participants would be meeting with an advisor every year or two and creating a personalized investing strategy. But that isn’t economically feasible; there’s no way a plan can pay for that.

What about advice for these investors down the road?

Right now, most Americans have relatively small balances. A target date fund might be the best place for them today, but as their situation changes and they accumulate wealth, hopefully, they’ll have a financial advisor who can help them figure out how they should be invested in their 401(k) plan or other plan.

I recently interviewed another expert who believes that investors should take more risk when they’re older and less when they’re younger. That’s opposite to the TDF strategy. What do you say?

I’ve seen research that talks about that. There are different perspectives. I believe that someone should become more conservative as they approach retirement. If the market drops by 40%, which it did in 2008, that’s OK if you’re 30 years old because you’ve got 35 more years to work.  But if you have a very aggressive portfolio just before you retire and the market goes down like that, you’re in trouble. You can’t make it back. To be fair, though, in the past even certain target date funds haven’t been very low-risk as [investors] approach retirement. They still held risky assets.

One of your own research studies found that risk preferences of investors of advanced age are influenced by the level of the S&P 500. Please explain.

An important aspect is that people tend to use target date funds at increasingly older ages. And they are the worst investors in defined contribution plans — I say that kind of tongue-in-cheek — because they have the most money. Therefore, the cost of a mistake is the greatest. They are also prone to making increasing errors in allocation when markets fall. Older participants have higher balances but tend to opt out at a higher rate than younger participants with lower balances.

Is it true that, in general, people don’t remain invested in TDFs for very long, as has been reported?

If you look at Vanguard, most people that get defaulted into a TDF tend to stay there. The problem is, though, that if you make the decision only one time, at some point you might do something silly, like move [everything] to cash.

Is there a way to avoid such silly moves?

What plans should be doing are re-enrollments where, if you’re not in the default, they’re going to put you back in it unless you opt out. You always have the choice to opt out of a default investment. But the goal is making the right decision; and that’s why we see participants increasingly using target date funds — most of them don’t want to build portfolios themselves. TDFs give them the age-appropriate way to do so.

How much access do 401(k) participants have to see what’s going on in their TDFs?

In theory, they have access all the time because most of them are mutual funds. But typically a TDF is a fund of funds; so you have to look at what funds it’s invested in. The big thing — the key — is that this is a multi-asset strategy. There’s no such thing as a truly passive target date fund. You can have the most passive product, like Vanguard [TDFs], but they still have to figure out what the glide path looks like and the weights of the asset classes. They’re making active decisions over time, and it’s not always clear how they make those decisions.

Much has been written about TDFs having high fees. Please comment.

I wouldn’t say there are high fees, but there can be. There’s definitely a spectrum of cost. Almost all the money is going to passive or low-cost options, like Vanguard. I think the average expense ratio is down to about 40 basis points.

As of December 2018, $1.7 trillion was invested in TDFs, according to Morningstar’s 2019 report. Do you forecast significant increases?

We definitely haven’t reached the saturation point. There are still going to be more participants and more assets going into TDFs over the next five to 10 years.

“The role of the defined contribution advisor has evolved in the past decade, and we expect the pace of change to accelerate,” you write. In what way will it change?

People want a personalized recommendation. Companies like Betterment are getting significant traction in assets, and I think we’re going to see some of that spillover effect in the defined contribution space because people want help; they want a personalized solution.

What are the implications?

Longer term, I’m not convinced that target date funds are going to be the best default for everyone because they’re not personalized enough. As we improve our technology solutions and other [components], it could be some kind of hybrid managed account target date fund solution. I have a hard time thinking that the right default is going to be the target date fund inside the defined contribution plan forever.

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