Target date funds are meant to be among the easiest of decisions for advisors helping their clients save for retirement.
"It should be simple. You stick in a date for retirement and should just set it and forget it,” says Tim Clift, chief investment strategist at Envestnet. “But there are many challenges.”
Choosing target date funds has become complicated in recent years by clients not knowing when — or if — they’ll retire, low bond yields, and an explosion of choices.
According to Morningstar Direct, target-date strategies totaled approximately $2.8 trillion in assets at the end of 2020, up roughly 22% from $2.3 trillion at the end of 2019, with market appreciation driving about 90% of that growth.
From determining a glide path to selecting the underlying funds, the role of target date fund managers cannot be underestimated. Funds with a common target date may take significantly different routes to get there. So how can advisors weigh all the options and pick the best choice for their clients?
Checking fees and philosophy
Since the last financial crisis in 2008, fees for target date mutual funds have come down while transparency has improved. According to Morningstar Direct, the average asset-weighted expense ratio for target date mutual funds was 0.52% in 2020, compared to 1.03% in 2009.
Notably, collective investment trusts, which typically have lower fees, have gained market share as more managers have begun offering them, and recordkeepers have made them more widely available to smaller plan sponsors. In fact, 2020 marked the first calendar year in which target-date mutual funds saw outflows since Morningstar started tracking such data in 2004.
"When these products were priced when they first came out, they were sort of mysterious,” says Philip Blancato, chief executive officer of Ladenburg Thalmann Asset Management at Advisor Group. Strategies were not very transparent and fees tended to be high, he adds. That came to a head in 2008 when some supposedly low-risk funds significantly underperformed, and investors learned that these managers were taking on more risk than expected, he says.
The result — lower fees and more transparency — highlights how critical understanding each firm’s approach to risk can be. Depending on the firm and its strategy, that risk can vary vastly, depending on the allocations to equities and fixed income and glide path. The average annual return for target date funds dated to 2060 or later was 15% in 2020 compared to an average return of 9% for funds in the retirement category dated 2020 or earlier, according to Morningstar Direct.
Due diligence experts say the risk disparity is especially prevalent now, given bond yields in the 1% to 1.5% range. Many portfolio managers diversify into asset classes such as high yield and emerging markets to generate more yield, says Clift, so advisors should look out for managers that are taking on added risk.
Another factor to watch, he says, is whether the target date fund goes “to” or “through” the target date. The latter group of funds will continue rebalancing assets along a glide path after the projected retirement date. The former group simply stops rebalancing once at the target date, often prompting advisors to move out of the products in favor of a new, more suitable investment.
Target date vs. target risk
With so many people unclear about when or whether they will retire, target risk funds, which keep their ratio of fixed income and equities within a particular range, are becoming more popular.
"Many people simply aren’t retiring anymore or are only partially retiring, in which case a target date fund might not be a good fit," says Blancato. For someone in their 60s who may be nearing retirement but plans to leave their money to the next generation, the relatively stable mix of a target risk fund might be more appropriate.
Target date funds also can be more complicated than risk-based funds for investors to follow, because the allocations change over time. Blancato stresses that it’s critical for advisors to explain to their clients how risk tapers off closer to retirement with target date funds and disabuse clients of the misconception that the funds are "fully engaged" in the market until retirement. "[T]hat’s not necessarily the case," he says.
"If markets are up 30%, the fund will not also be up 30%,” Blancato explains, acknowledging that the diversification of assets can curb risk, but also limit upside. "That’s where the financial advisor has to be very proactive and understand what is it you’re actually getting in these funds, so they can set the expectations," says Blancato.