June 2018 Target date funds: Why the to vs. through analysis falls short and what you should be considering
Executive Summary Jake Gilliam Head Client Portfolio Strategist, Multi-Asset Strategies, Charles Schwab & Co., Inc. Primarily responsible for contributing to strategic decisions for all multi-asset class portfolios as well as several single asset-class portfolios within CSIM and Schwab Bank Collective Trust Funds. Mr. Gilliam also represents CSIM s multi-asset class strategies to the institutional marketplace, clients, and the media. Target date funds (TDFs) are a substantial and growing segment within the qualified default investment alternative (QDIA) space, representing professionally managed, single-vehicle investment solutions. However, not all TDFs employ the same investment philosophy, and there are important distinctions between TDFs to consider. To date, much time and energy comparing TDFs has been spent on whether the equity landing point occurs at the retirement year, or beyond. However, we believe that instead of such an approach, plan sponsors should critically examine how fund architecture, risk management, and the evolution of investment mix throughout a fund s glide path can complement one another to address the needs and demographics of plan participants. This paper offers actionable guidance that plan sponsors can employ to help evaluate whether a TDF appropriately balances its potential for growth while reducing the level of risk as an investor approaches retirement, and beyond. 1 2 3 Key takeaways Kevin Bowman Director, DCIO Channel Management, Charles Schwab & Co., Inc. Primarily responsible for initiatives to grow and support CSIM s defined contribution investment-only business. While the question of whether or not a TDF s glide path extends to or through a given point in time is important to understand, we believe that plan sponsors should look beyond this comparison. Contrary to common belief, TDFs with to glide paths are not always more conservative than those with through paths; in fact, a through fund may potentially provide better downside protection while benefitting investors well past its target date. Within a fund s glide path, plan sponsors should consider the asset allocation, architecture type, and methods for managing absolute risk. Asking the right questions helps plan sponsors to select a TDF series that will meet the needs of their participants. Target date funds: Why the to vs. through analysis falls short and what you should be considering 2
Introduction Target date funds have become a large and important part of employer-sponsored retirement plans like 401(k)s, largely in response to The Pension Protection Act of 2006, which allows employers to enroll employees automatically in workplace retirement plans. The law permits plan sponsors to invest workers contributions in default investments, called qualified default investment alternatives (QDIAs), which must be appropriate and capable of meeting a worker s long-term retirement savings needs. TDFs, which are professionally managed and automatically rebalance to become more conservative as an employee gets closer to retirement, have become the most popular QDIA choice for plan sponsors. However, the TDF marketplace is large and growing comprising of 60 mutual fund series at year-end 2017 1 making it increasingly difficult for plan sponsors to identify a TDF series that offers the best mix of investment characteristics for their plan participants. Part of this difficulty stems from the prevalence of what we believe to be a shortsighted method for evaluating TDFs: that is, whether funds designed to get investors to a targeted point in time, or those engineered to continue shifting their allocations past or through this point in time, are more appropriate for retirement-focused savers such as 401(k) plan participants. TDFs have evolved significantly in recent years, with various nuances and construction differences. As a result, the traditional to vs. through analysis is proving too rudimentary: it oversimplifies what is an incredibly important fiduciary decision. In our view, a plan sponsor s due diligence of TDFs should instead revolve around a number of more sophisticated criteria that, when looked at comprehensively, better determine a fund family s viability as a prudent long-term solution for plan participants and sponsors alike. We believe more detailed aspects of asset allocation, diversification, fund selection, and evolution of investment mix over time are all critical differentiators in determining the suitability of a TDF series, beyond just analyzing the landing point of stocks and bonds. This paper explores these factors and provides actionable guidance that plan sponsors can use to evaluate the appropriateness of a TDF series for their plan and its participants. 1 Morningstar 2018 Target-Date Landscape with data as of 12/31/2017. Target date funds: Why the to vs. through analysis falls short and what you should be considering 3
Why to vs. through is not enough Many industry pundits and the media tend to focus their attention to TDFs on whether a to or through approach is most effective. In to funds, equity exposures typically slide downward and reach their lowest level on the target date. By contrast, through funds do not reach their lowest equity concentrations on a specific date, but rather continue to decrease exposure through the target date and into retirement. Through funds are often perceived as inherently riskier than to funds. Contrary to this popular belief, however, to funds are not necessarily more conservative, and through funds can potentially provide better downside protection while benefitting investors well past a fund s target date particularly if the fund is thoughtfully designed. Rather than remain mired in the to or through debate, plan sponsors should instead evaluate a TDF family by looking at three important features: 1. Asset allocation 2. Underlying fund architecture 3. Risk These features, when considered alongside plan sponsor goals and investor demographics such as age, salary, contribution rates, likely risk tolerance, average level of assets, and behavior at retirement, should help plan sponsors understand whether a TDF family meets participant needs and fiduciary requirements, particularly in relation to QDIA compliance. We believe these underlying considerations to be far more revealing about the suitability of a TDF family than the simple to vs. through approach. One of the chief factors plan sponsors should consider when determining the relative merits of a TDF family is its asset allocation approach. 1. Asset allocation One of the chief factors plan sponsors should consider when determining the relative merits of a TDF family is its asset allocation approach that is, how much exposure the funds have to certain asset classes. Asset allocation is important because it signifies how the funds aim to balance risk and reward potential in the portfolio. In general, the more diverse the underlying asset allocation, the less volatile the funds tend to be. It used to be that a simple mix of stocks, bonds, and cash was believed to provide adequate diversification. Increasingly, however, TDF managers are broadening their approach to asset allocation. Why? Because stocks and bonds are not homogenous categories there are sub-asset classes and sectors within each category that carry their own risk profiles and return expectations. Therefore, two TDFs that have seemingly similar allocations to stocks, bonds and cash at their target dates say 40%/55%/5% could expose participants to very different levels of risk. Take stocks, for instance. Asset allocation is no longer about placing 40% (or 30% or 50%) of a portfolio in equities. This is because the stock category itself is huge, composed of many layers of sub-asset classes. For example, you could divide stocks into domestic and international sub-asset classes, and then divide each of those into small-, medium- and large-cap asset classes, as well as by growth or value characteristics, and even by sectors and industries. You could also break down the international stocks by type of economy, such as developed, emerging, or frontier markets. There also are stock-like securities such as real estate investment trusts, master limited partnerships and preferred stocks to consider. And each class of stock has markedly different risk and reward profiles than the others. The fixed income market is similarly diverse. Treasuryissued securities have unique traits compared to high-yield bonds and mortgage-backed securities. Target date funds: Why the to vs. through analysis falls short and what you should be considering 4
Government-issued debt in emerging markets has a very different risk/reward profile than high-grade corporate bonds in developed nations. Duration opens another dimension in bond portfolio variety: a portfolio skewed to long-term bonds might be more vulnerable to volatility than a short-term-dominated portfolio, especially in an environment where interest rates are rising, or poised to rise. In short, wide differences exist in how TDF managers approach asset allocation and diversification and these differences in investment philosophy and practice can, especially over time, have a marked impact on a fund s performance, regardless of whether it employs a to or through approach. It is not enough to ensure that a fund family is adequately diversified plan sponsors also need to ensure that the funds employ a sophisticated approach to adjusting asset allocations over time. It is not enough to ensure that a fund family is adequately diversified plan sponsors also need to ensure that the funds employ a sophisticated approach to adjusting asset allocations over time, so that risk exposure is reduced as a participant 1 2 3 Takeaway When evaluating TDF families, plan sponsors should look for funds with a sophisticated mix of assets that provide diversified exposure to a broad swath of the investable world. Plan sponsors should also ensure that the TDFs are adjusting their asset allocations over time in order to reduce risk as participants age. ages. Exposure to riskier sub-asset classes, such as emerging market stocks and high-yield bonds, might be reduced or eliminated entirely, while exposure to more conservative sub-asset classes, such as domestic large caps and U.S. Treasuries, might increase. Thus, the funds asset allocation and diversification should evolve to reflect the changing needs of your plan s participants. (For more on this topic, see 3. Risk on page 6.) 2. Underlying fund architecture Plan sponsors should also investigate how a fund is architected that is, what kinds of underlying funds it holds and how that could impact fund performance over time. TDFs that invest only in proprietary active strategies those operated by the firm offering the TDF have what is known as closed architecture. Other TDFs deploy open architecture, which means they may include funds or strategies managed by other firms exclusively, or alongside their own proprietary funds. As part of their due diligence, plan sponsors seeking a TDF with active management exposure (using strategies that attempt to add value relative to an index or benchmark) should understand the key differences between proprietary-only and open-architecture TDFs. We believe openarchitecture TDFs offer four benefits that make them attractive to many plan sponsors: diversification, cost, track record and flexibility. Diversification: Active open-architecture TDFs often offer a diverse mix of investing styles because managers can seek out leading active managers who provide a broad range of research, processes and schools of thought about the markets. Conversely, closedarchitecture TDFs leverage only the research, analysts and economic outlook provided by their proprietary managers. Target date funds: Why the to vs. through analysis falls short and what you should be considering 5
Cost: Because of their flexible nature, openarchitecture funds might be able to negotiate on price in a competitive search process. These lower costs often translate into savings for plan sponsors and participants. Track record and flexibility: When selecting active strategies, open-architecture TDFs can define the criteria for the type of exposure they want, and therefore seek out managers and funds with demonstrated expertise. Conversely, closedarchitecture TDFs are limited to offering what s on their shelf, so while they may be able to offer a product to fill a particular slot, it can be harder for them to demonstrate their process for selecting the best strategies for plan participants. And, with a wider universe of available strategies, portfolio managers can benefit from a greater ability to make changes or additions to the underlying funds. Having a wide array of fund choices enables TDF managers to cultivate a diversity of thought on top of diversified asset allocations. Unlike funds that are limited to using only proprietary active products, open-architecture TDFs can select from an unconstrained universe of strategies, and make adjustments as warranted. This helps mitigate the potential for conflicts of interest and provides better diversification, which should lead to a smoother ride for plan sponsors and participants alike. A common misconception about to funds is that, because they tend to have less exposure to stocks at their target dates, they are inherently less risky. 3. Risk A common misconception about to funds is that, because they tend to have less exposure to stocks at their target dates, they are inherently less risky. The problem with this belief is that it does not account for absolute level of risk over the course of the TDF s glide path. We believe it is more useful to understand how or if a fund s absolute level of risk decreases as participants move through retirement. Plan participants age and risk tolerance, as well as market conditions, may combine to argue for higher or lower equity allocations throughout retirement. A to fund with 40% exposure to equities at its target date which may seem like a reasonable exposure at retirement may prove to be a relatively high allocation if it is held constant and held by retirees late into their lives, when a 40% allocation for someone in their 80 s may no longer seem as prudent. Other TDFs might take a different approach, reducing equity exposure throughout retirement in order to reduce risk while still maintaining some growth potential for retirees. 1 2 3 Takeaway When evaluating TDFs with active management exposures, it is important to remember that any one firm is unlikely to offer the best strategies with demonstrated track records in every asset category. We believe that those TDFs with the freedom to bring top active funds or sub-advisers together under one umbrella, regardless of the firm with which they are associated, are worth considering for plan sponsors and plan participants alike. Target date funds: Why the to vs. through analysis falls short and what you should be considering 6
Glide path variables An effectively developed glide path should grow more conservative as retirement approaches, adjusting its asset classes, asset allocations and management styles to ensure proper alignment for plan participants. As Retirement Approaches Equity Portfolio LESS... Active Strategies Domestic Small Cap International Emerging Markets MORE... Passive Strategies Domestic Large Cap Domestic International (Developed) Fixed Income/ Cash Equivalents Portfolio Active Strategies Credit Risk Duration International Passive Strategies Inflation-Protection (U.S. TIPS) Short-Term Bonds & Cash Equivalents Domestic For illustrative purposes only. Glide paths should take into account multiple variables, including participant behavior and tolerance to volatility. Glide paths should take into account multiple variables, including participant behavior and tolerance to volatility. As the fund s target date approaches, its glide path should begin to shift focus away from wealth accumulation and toward downside protection. Upon reaching the target date, the emphasis should then shift to capital preservation in order to help ensure the plan participants funds last as long as possible. This is not to say allocations should become less diversified in retirement. On the contrary, we believe that diversified exposure in retirement is essential, especially as people continue to live longer and more productive lives. Maintaining adequate diversification helps mitigate risk, which in turn helps ensure that plan participants needs will continue to be met throughout retirement without depleting their account balances too quickly. As with asset allocation, a glide path is far more than a number it is a weighting of assets distributed within a portfolio. As with asset allocation, a glide path is far more than a number it is a weighting of assets distributed within a portfolio. Practically speaking, there is near unanimity about lowering equity exposure over the course of a glide path. But the details of how this Target date funds: Why the to vs. through analysis falls short and what you should be considering 7
Sample to approach: A static investment philosophy The asset allocation of a to approach remains static after the TDF reaches its target date, with limited ability to adjust as an investor s needs and risk tolerance continue to become more conservative. 100% 90% 80% Fixed Income Cash 70% 60% 50% Equities Continuous Allocation 25% Equities 65% Fixed Income 10% Cash 40% 30% 20% 10% Starting Allocation 95% Equities 5% Fixed Income 0% Cash Target Date 25% Equities 65% Fixed Income 10% Cash 0% 45 40 35 30 25 20 15 10 5 0 +5 +10 +15 +20 +25 Years Before Target Date Target Date Years After Target Date Large Cap Mid-Cap Small Cap International Equity Diversified Emerging Markets Global Real Estate Commodities Broad Basket World Bond Intermediate- Term Bond Short-Term Bond Cash Equivalents Inflation- Protected Bond The target date is the date when investors are expected to begin gradual withdrawal of fund assets. For illustrative purposes only. is accomplished are critical. As the glide path progresses, we believe TDFs should reduce holdings to asset classes and management styles that tend to carry greater risk, such as funds that are actively managed or those that focus on assets with higher volatility and potential for large capital losses, such as domestic small caps and emerging markets. As an example, consider a to fund that culminates in a 35% equities holding when an investor reaches age 65. That same portfolio would hold a little more than a third of its assets in equities when the investor celebrates turning 75, 90 or even 100. While that allocation might prove successful, its rigid adherence to the 35% stock stake does not appear to take into account the investor s changing needs and risk tolerance during an investor s later years. Target date funds: Why the to vs. through analysis falls short and what you should be considering 8
Sample through approach: An evolutionary investment philosophy The asset allocation of a through approach continues to adjust even after a TDF reaches its target date, shifting its asset mix to suit the needs of plan participants who are enjoying their golden years. 100% 90% 80% Fixed Income Cash 70% 60% 50% Equities Final Allocation 25% Equities 66% Fixed Income 9% Cash 40% 30% 20% 10% Starting Allocation 95% Equities 5% Fixed Income 0% Cash Target Date 40% Equities 53% Fixed Income 7% Cash 0% 45 40 35 30 25 20 15 10 5 0 +5 +10 +15 +20 +25 Years Before Target Date Target Date Years After Target Date Large Cap Mid-Cap Small Cap International Equity Diversified Emerging Markets Global Real Estate Commodities Broad Basket World Bond Intermediate- Term Bond Short-Term Bond Cash Equivalents Inflation- Protected Bond For illustrative purposes only. In contrast, a through fund might land at 40% equities when the investor hits age 65 and then gradually decline to 25% by age 85, focusing mainly on large-cap domestic stocks, reducing the portfolio s risk to market volatility and accounting for investors changing needs as they live through retirement. Similarly, it is important to consider how a fund s glide path increases exposure to fixed income over time. Plan sponsors should consider how a TDF manager balances perceived benefits of fixed income (such as stability and income preservation) with the potential drawbacks (such as interest-rate and credit risk). For example, as the fund progresses beyond its target date, a manager might choose to place more prominence on investments that offer stability and combat risk, such as short-term bonds, cash equivalents, and TIPS, and reduce exposure to investments that carry too much credit or interestrate risk. In the end, balance should be a central consideration: plan sponsors should evaluate how a fund manager is maintaining adequate growth potential while reducing the TDFs overall level of risk. Target date funds: Why the to vs. through analysis falls short and what you should be considering 9
1 2 3 Takeaway When evaluating TDFs, it is important to look inside the glide path and fully understand how a TDF manager approaches glide path allocations over time. Some holdings within stocks and bonds are inherently riskier than others, so paying attention to the high-level breakdown of stock, bond and cash allocations isn t enough. Plan sponsors should consider absolute risk how the fund manager is balancing asset longevity with market- and investment-specific risk when selecting TDFs for their plans. Conclusion More and more employee-sponsored retirement plans are turning to TDFs, automatically enrolling participants to help ensure they will have enough savings to fund their retirement. TDFs have a lot going for them: they are low maintenance, provide diversification, rebalance holdings automatically, and shift to a more conservative allocation over time. There are now more than 60 1 TDF mutual fund series and they represent a wide range of approaches and strategies. Therefore, it is critical for plan sponsors to choose the best TDF solution for their employee base and ensure that the funds they offer are structured, built and managed in ways that comply with QDIA requirements and meet the expectations of their plan participants. Instead of focusing on a simplistic to vs. through approach for evaluating a TDF series, we believe plan sponsors need to focus on how three critical differentiators asset allocation, fund architecture and risk management complement the needs and demographics of their plan participants. By focusing on these three factors, we believe plan sponsors will be better equipped to find a TDF family that will help plan participants achieve their long-term savings goals and enjoy a financially healthy retirement. 1 Morningstar 2018 Target-Date Landscape with data as of 12/31/2017. Target date funds: Why the to vs. through analysis falls short and what you should be considering 10
Charles Schwab Investment Management As one of the nation s largest asset managers, our goal is to provide investors with a diverse selection of foundational products that aim to deliver consistent performance at a competitive cost. Not FDIC-Insured No Bank Guarantee May Lose Value For the Schwab Target Index Funds and the Schwab Target funds, investors should consider carefully information contained in the prospectus, or, if available, the summary prospectus, including investment objectives, risks, fees, charges and expenses. You can request a prospectus for Schwab Funds by visiting www.schwabfunds.com. Please read the prospectus carefully before investing. Target date fund asset allocations are subject to change over time. The principal value of the funds is not guaranteed at any time, and will continue to fluctuate up to and after the target date. There is no guarantee the funds will provide adequate income at or through retirement. The funds are built for investors who expect to start gradual withdrawals of fund assets on the target date, to begin covering expenses in retirement. Target date fund asset allocations are subject to change over time in accordance with each fund s prospectus. The funds are subject to market volatility and risks associated with the underlying investments. Risks may include exposure to international and emerging markets, small company and sector equity securities, and fixed income securities subject to changes in inflation, market valuations, liquidity, prepayments, and early redemption. Diversification strategies do not ensure a profit and do not protect against losses in declining markets. This information is being furnished as educational and is not intended to constitute investment advice. Readers are expected to consult with their legal or financial advisors as applicable. The material in this presentation is based on information from a variety of sources we consider reliable, but we do not represent that the information is accurate or complete. Errors and omissions can occur. None of the information constitutes a recommendation by Charles Schwab Investment Management or a solicitation of an offer to buy or sell any securities. Charles Schwab Investment Management, Inc. (CSIM), the investment advisor for Schwab Funds, and Charles Schwab & Co., Inc. (Schwab), Member SIPC, the distributor for Schwab Funds, are separate but affiliated companies and subsidiaries of The Charles Schwab Corporation. Schwab Bank Collective Trust Funds The Charles Schwab Collective Trust Funds ( Funds ) are maintained by Charles Schwab Bank ( Schwab Bank ), trustee of the funds, and are available for investment only by eligible retirement plans and entities. The Funds are not mutual funds and are exempt from registration and regulation under the Investment Company Act of 1940 (the 1940 Act ), and their units are not registered under the Securities Act of 1933, or applicable securities laws of any state or other jurisdiction. Unit holders of the Funds are not entitled to the protections of the 1940 Act. The decision to invest in the Funds should be carefully considered. The Funds unit values will fluctuate and may be worth more or less when redeemed, so unit holders may lose money. The Funds are not sold by prospectus and are not available for investment by the public; Fund prices are not quoted in newspapers. CSIM, Schwab Bank s affiliate, provides non-discretionary advisory service to the Funds, including research and recommendations relation to asset allocation, portfolio construction, cash-flow monitoring and adviser selection and retention. 2018 Charles Schwab Investment Management, Inc. All rights reserved. IAN (0618-8WEG) MKT86668-04 (06/18) 00212045 For more insights, visit us at www.schwabfunds.com