Don’t be a Target Date Fund Victim
- Target Date Funds (TDFs) have three interest groups: investment managers, fiduciaries, and beneficiaries
- The interests of these three groups are not aligned.
- If you’re in a TDF, you’ll lose in the next market correction because of these misalignments. Don’t let this happen to you.
- You can and should create their own conflict-free target-date portfolio
TDF Interest Groups
Investment managers create TDFs for profit, which is, after all, their business. Fiduciaries choose TDFs, presumably for the benefit of participants, but that’s not what they do. Beneficiaries want to be protected, especially as they enter retirement, but they are actually exposed to substantial risk. In the following, we discuss the interests of each of these groups with the intention of moving those interests toward better serving beneficiaries. Don’t let yourself fall victim to interests that are not aligned with yours:
The SEC just recently called out investment managers for not disclosing the conflict of interest in “proprietary” TDFs where the underlying funds are managed by the TDF provider. These conflicted funds are sometimes called “closed architecture” as contrasted to “open architecture.” 95% of TDF assets are held in proprietary closed architecture funds, according to Sway Research, which studies asset management distribution in retirement plans. Many believe that open architecture delivers better performance because best of breed funds are used, but Morningstar reports that this is generally not true. So this conflict matters, but not as much as the misalignment of risks away from what beneficiaries want.
Investment managers have seized upon the TDF opportunity to package products, populating glide paths with proprietary funds. The major misalignment with beneficiary best interests is at the target date, where the typical TDF is 55% in equities which is riskier than the allocation in 2008 that lost 30%. Risk is born by beneficiaries, not fund companies who get paid a premium for higher risk regardless of the outcome. Allocations at the target date are the most important because assets are likely to peak at that date. Management fees for equities are higher than those for bonds. Equities also win the performance horserace, until they don’t.
Investment managers sell risky allocation as the solution for inadequate savings. Growth trumps safety because participants have not saved enough. Read more on this hogwash in the Human Face of TDFs.
The misalignment of investment manager interests is compounded by the fact that the TDF industry is an oligopoly dominated by just 3 firms, as shown in the next picture. Oligopolies are never good for consumers.
The oligopoly began when target-date fiduciaries handed over their TDF assignment to their bundled service providers out of convenience and familiarity. T Rowe, Fidelity, and Vanguard are the largest bundled service providers. Then as assets grew, it became almost mandatory that investment consultants select the Big 3 because procedural prudence dictates that you do what everyone else is doing. This leads to the next conflict.
Fiduciaries, namely plan advisors and trustees, want to protect themselves against lawsuits and believe that (1) any Qualified Default Investment Alternative (QDIA) will do, and (2) you can’t wrong with the Big 3 oligopoly because everyone else is using them. This is a breach of the Duty of Care that, like our duty to protect our children, holds fiduciaries responsible for harm to our dependents that should have been prevented. Fiduciaries are duty-bound to seek the best TDFs for their beneficiaries, but this is not happening. The next market correction could bring lawsuits that remedy this imprudent practice.
It boils down to the question ”Who is the client?” The ultimate consequences of the TDF choice are felt by the beneficiaries, so they really should be the client. Plus the laws are designed to protect the beneficiaries. But plan sponsors pay the bills and hire and fire consultants, so sponsors are the clients that consultants want to make happy. Sponsors and their consultants are fiduciaries who want to be protected, even if it means that beneficiaries are not protected, as discussed in the next section.
Most assets in TDFs are there by default. They belong to employees who can’t decide how to invest their savings. Beneficiaries do not choose TDFs. Their employer chooses, and most employers hire consultants to make this choice.
Beneficiaries want to be protected as they enter retirement, and may think they are protected, but they are not. Some beneficiaries even report that they think TDFs carry a guarantee of principal.
A recent MassMutual Retirement Savings Risk Study examines beneficiary risk preferences in 401(k) plans, summarized as follows:
At 15 years to the target date, the vast majority (75%) want growth over safety, but this preference shifts dramatically so that only 17% prefer growth over safety at retirement. Also shown in the graph, those with another source of income, like a DB plan, opt for somewhat more growth, obviously because their other assets are safe.
The unfortunate result is that most TDF beneficiaries are not getting the protection they want and need in the critical Risk Zone that spans the transition from working life to retirement. As shown in the following picture, the Oligopoly is about 55% in equities for those near retirement, while the survey shows that participants want much less risk. Accordingly, the next market correction could be a real shock because beneficiaries will come to realize how exposed they are to losses
Because of disparate interests, there are winners and losers and chumps in TDFs. Investment managers are winning big time since $2 trillion has poured into TDFs in just the past decade. Beneficiaries will be the big losers in the next market correction, but this could be avoided if investors take back control of their retirement savings by investing in personalized target portfolios.
Personalized target-date portfolios are built specifically for the investor, by the investor, so they are conflict-free, They also solve the one-size-fits-all problem that all TDFs suffer from. GlidePath Wealth Management can help.
Don’t be a victim.