How to Build a Better TDF
The defined contribution (DC) industry has devoted tremendous amounts of time and effort to improve the likelihood of successful retirement outcomes. But much like the ancient Roman goddess Fortuna capriciously interfering in the lives of mortals, random economic and market forces largely drive retirement outcomes.
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One of those random market forces is sequence-of-returns risk. To illustrate its impact, Callan examined hypothetical participant outcomes for various time periods. By virtue of external factors—in this case, when one began saving and retired—their outcomes varied tremendously, our study found (by as much as a factor of 2.5x!).
So how can those random external forces be moderated? Diversification is an investor’s one free lunch. But the diversification within TDFs rarely extends outside mainstream asset classes. So why are target date managers not offering alternative asset classes? For one thing, fees. When adding any alternative asset class, the expected improvements to outcomes must clearly outweigh any potential increase in fees. When looking at private assets (e.g., real estate or hedge funds), barriers go beyond fees. Daily valuation (and to a lesser degree daily liquidity) remains the price of admission to the DC market, so managers of such products must get creative. But they must take care not to water down the strategies to the point where their benefits no longer exist.
Improving the Distribution Phase with Annuities
Helping retirees draw down assets during the distribution phase represents the next great puzzle facing the DC system. Retirement income solutions remain a rarity, though innovation in the form of guaranteed income products, managed payout solutions, and laddered bond portfolios forges ahead.
Already some providers of off-the-shelf TDFs offer versions with guaranteed income streams, in which a portion of the underlying assets is invested in a sleeve that contains an annuity payout. But as with many innovative financial products, cost and operational issues present difficulties. For those looking to purchase an immediate annuity upon retirement, a balance of $100,000 translates into a paltry figure of roughly $523 a month. Given the sticker shock, the lack of interest in annuities should come as no surprise.
Despite these issues, the distribution phase represents another area where we may see continued evolution in the target date market.
More Targeted Target Date Funds
One criticism of TDFs is that the glidepath is one-size-fits-all. In an effort to refine the target date approach, some providers are looking to incorporate information beyond a participant’s age when building their asset allocation. Often referred to as dynamic QDIAs, these products use information such as marital status, additional assets, DB plans, historical contribution rates, etc., to build a more customized asset allocation.
But human nature is a stumbling block. Although recordkeepers can provide some of the data required, few participants supply additional information. And in the current atmosphere of cybersecurity risk, participants may prove reluctant to aggregate so much sensitive information in a single place.
Pundits may argue as to whether the target date industry is on version 2.0, 3.0, or 4.0. Whatever the case, we know for certain that TDFs will continue to evolve, with increasing liquidity and lower costs expanding the range of asset classes available to target date providers. Technology improvements also provide another source of innovation.
The opportunity for those that can overcome these largely operational hurdles is immense. Every day, 10,000 baby boomers retire. Thomas Edison summarized what we in the retirement industry now must do: “There’s a way to do it better—find it.”
My paper, “Reaching for Higher Ground: Progress and Pitfalls in the Continued Evolution of Target Date Funds,” offers a more detailed look at ways of improving TDFs for participants.