The Ins and Outs of Target Date Funds and the New L Funds TSP

Default Option- Part 1 https://learn.extension.org/events/2030#.VQwbhk0tGM8

Barbara O’Neill, Ph.D., CFP® Rutgers Cooperative Extension

Workshop Objectives- Part 1

Learn background, history, and characteristics of target date funds

• Learn advantages and disadvantages of target date funds

• Learn the difference between target date (lifecycle) funds and lifestyle funds

• Learn how glide paths work

• Learn about target date fund resources

Question #1: Do you invest in target date mutual funds? If so, which one(s)?

Take-Away #1: TDFs become more conservative automatically

What is a Target Date Fund (a.k.a., Lifecycle Fund)?

• Diversified mutual fund portfolio consisting of 3 asset classes: stocks, bonds, cash equivalents

• Asset allocation automatically adjusts; becomes more conservative (less stock) over time

• Typically “fund of funds” with underlying funds from the same fund family

– Vanguard Target Retirement Funds

– Fidelity Freedom Funds

– Thrift Savings Plan (TSP)

Target Date (Lifecycle) Funds vs. Lifestyle Funds • Two different types of mutual funds that are often confused

due to similar names

• Both are “all-in-one” portfolios containing several different asset classes

• Target date (Lifecycle) funds have a future date in their name and automatically adjust from an aggressive to a conservative asset allocation over time

• Lifestyle (a.k.a, target risk) funds have different portfolios with different asset allocation % weightings; investors choose a portfolio to match risk tolerance level; portfolio won’t adjust over time (investors would need to change portfolios)

Target Date (Lifecycle) Funds vs. Lifestyle Funds

Lifecycle (Target Date) • Manages money toward

an investor’s future target date

• Takes the guesswork out of the process of reducing investment risk over time

• Low maintenance approach

Lifestyle (Target Risk) • Manages money

according to investor’s risk tolerance level

• Provides more consistent exposure to a certain amount of risk over time

• Requires investor decisions and action to make changes

Distinguishing Trait: Mutual Fund Name

Lifecycle (Target Date)

• Generally identified by a DATE in their title

• Examples: 2020 fund, 2030 fund, 2050 fund, etc.

Lifestyle (Target Risk)

• Generally identified by a RISK LEVEL WORD in their title

• Examples: Growth Fund, Moderate Growth Fund, Conservative Growth Fund, Income Fund (Vanguard)

Selected Trade Names Lifecycle (Target Date)

• Vanguard Target Retirement Funds

• Fidelity Freedom Funds

• T. Rowe Price Retirement Funds

Lifestyle (Target Risk)

• Vanguard LifeStrategy® Funds (4 portfolios)

• Fidelity Asset Manager® Funds (7 portfolios)

• T. Rowe Price Personal Strategy Funds (3 portfolios)

More About Target Date Funds • Also referred to as “age-based” funds

• Target date is the year an investor plans to retire and stop making new deposits to fund (+/-) 5 years

– Dates spaced at 5- or 10-year intervals (2030, 2035, etc.)

– If retiring in between two target dates, can choose one or the other nearest date or a combination of two close dates

Example: If planning to retire in 2022, could use a 2020 fund or 2025 fund or both

– If a conservative investor, “go shorter” (2020)

– If an aggressive investor, “go longer” (2025+; more stock )

Sample Target Date Mutual Fund Portfolios

More About Target Date Funds • Equity and fixed-income assets in one mutual fund

• Vanguard and Fidelity are two largest suppliers of target date funds; composition and expenses vary

– Vanguard includes passively managed (index) funds

– Fidelity includes actively managed funds

• Only make sense if they include most of your retirement investments

– Otherwise, you alter your overall asset allocation and contradict the whole premise of using TDFs

Take-Away #2: Three key performance factors are fees, underlying funds, and glide paths

Question #2: What is a target date fund glide path?

More About Target Date Funds • Have gained popularity in last decade • Popular “qualified default investment alternative”

(QDIA) for tax-deferred employer retirement plans • Typically formed as open-end investment companies • Defining characteristic is glide path, which determine

asset mix of the fund over time

More About TDFs as QDIAs • Default investments are especially important in

employer retirement plans with automatic enrollment

• Some employees who are enrolled in employer retirement plans fail to provide instructions for investing their deposits

• If workers do not select investments for their retirement account, employer puts money in the default investment

• U.S. Department of Labor approved TDFs as an appropriate Qualified Default Investment Alternative

The Glide Path is Critical! • Determines starting target date fund asset allocation

and how quickly it will change

• Generally becomes more conservative over time

• Three key elements:

– Initial equity allocation

– Slope of the glide path

– Equity landing point (i.e. date after retirement when the equity-to-fixed-income ratio remains unchanged throughout rest of retirement)

http://www.pionline.com/article/20140818/PRINT/308189983/some-target-date-funds-are-boosting-equities

Glide Paths Vary Among TDF Providers

• Glide path: how equity (stock) % changes over time; a critical determinant of wealth creation outcomes

• Found in both TDFs for retirement and age-adjusted portfolios in 529 college savings plans

• Each TDF provider establishes its own glide path and glide paths can vary considerably

• Three glide path methods: – Straight line: Steady, linear approach to gradually reduce stocks

(Vanguard and TIAA-CREF)

– Stepped: Equities allocation is periodically adjusted in stages (ING)

– Rolldown: High equity level until about 20 years before retirement and then a sharp reduction begins (Fidelity)

http://www.bogleheads.org/wiki/Glide_paths

Glide Path Illustrations Straight Line

Stepped

Rolldown

Source: http://www.bogleheads.org/wiki/Glide_paths

“To” and “Through” Glide Paths • “To” Glide Path- Assumes that retirement age is the

target date; at that point, the portfolio’s stock % and investment mix remains static

• “Through” Glide Path- The equity allocation continues to decrease for a designated number of years after retirement before leveling off

• Landing Point- The point in the glide path where the TDF reaches its lowest equity allocation

• TDFs with different glide paths and landing points have very different risk profiles

Through Retirement TDF With 25 Year Stock Landing Point

Source: U.S. Securities and Exchange Commission

Question #3: What type of glide path does your TDF have? The TSP L fund?

Take-Away #3: Performance among TDFs can vary dramatically

TDF Industry Examples http://www.wealthinformatics.com/2011/04/17/do-you-know-your-target-retirement-funds-glide-path/

Describes starting equity %, type of glide path, and equity landing point for five TDFs • Fidelity Freedom • Vanguard Target Retirement • T. Rowe Price • TIAA-CREF • ING Solution

More About Target Date Funds • As an “all-in-one” investment, should have exposure

to wide range of asset classes

– Fidelity uses 23 underlying mutual funds

– Vanguard uses 3 broad index funds

• Key factors to consider

– Fund’s investment style

– Fund’s historical performance

– Fund’s fees and expense ratio

http://www.investopedia.com/articles/mutualfund/05/051005.asp

Investment Style Target Date Fund Itself • Strategic vs. Tactical

– Strategic: Rebalance portfolio to target asset %s – Tactical: Change portfolio in response to current

market conditions Underlying Mutual Funds • Active vs. Passive

– Active: Use actively managed funds to try to outperform benchmark index

– Passive: use index funds to track a benchmark index

More About Target Date Funds • Fastest growing asset class used in employer defined

contribution (DC) plans

• Make up about 20% of DC plan market

• $670.6 billion in TDF assets in 2014

• TDF assets could double in size by 2018

• TDF suppliers include Vanguard, Fidelity, T. Rowe Price, BlackRock, JP Morgan, Principal Financial, and American Funds

http://online.barrons.com/articles/SB50001424053111904544004579651134019266274

Target Date Fund Evolution Process: 1980s-2013

• 1980s: 401(k)s become a supplemental retirement savings plan; 3-legged stool of Social Security, a defined benefit pension, and savings is still intact

• 1990s: Beginning of the “do it yourself” retirement model; more 401(k)s introduced as sole retirement plan and fewer DB pensions

• 2000s: “Do-it-for-Me” model introduced and TDFs gain popularity; defined contribution (DC) plans become primary retirement savings vehicle

Target Date Fund History • First target date funds created in 1994 by Wells Fargo and

Barclays Global Investors

• Responded to 401(k) plan participants’ failure to prudently manage their retirement plan portfolios for 10+ years

• Plan participants wanted someone to make 401(k) investment and asset allocation decisions for them

• Institutions needed to develop a strategy to use with millions of plan participants

• Participants were aggregated into age-based cohorts http://www.ucs-edu.net/cms/wp-content/uploads/2014/04/I_ABriefHistoryOfTargetDateFunds.pdf

More Target Date Fund History • 1996: Fidelity Freedom TDFs

• 2001: Principal LifeTime TDFs

• 2002: T. Rowe Price Retirement TDFs

• 2003: Vanguard Target Retirement TDFs

• 2006: Pension Protection Act (2007 for final regs) lead to increased use of TDFs in DC plans

– Created a “safe harbor” for TDFs as a Qualifying Default Investment Alternative in auto-enrollment DC plans

• 2008: Performance issues raise concerns by SEC and investors, especially for near-term (2010) TDFs

More Target Date Fund History • 2008- TDF investors and regulators became very

aware that “all glide paths are not created equally” • 2009- SEC and Department of Labor hearings on

TDFs; critics claimed TDFs were not as conservatively positioned as their names implied

• 2010- New TDF disclosure rules published by the SEC, including better description of glide paths

• 2013- 36 target date mutual fund firms; 2010 TDFs were only category to “leak” assets (retiring boomers)

• 2015- L fund becomes TSP default option (10/15) http://corporate.morningstar.com/us/documents/MethodologyDocuments/MethodologyPapers/2014-Target-Date-Series-Research-Paper.pdf

Take-Away #4: Knowing a TDF’s glide path is critical to understanding its risk profile

Target Date Fund (TDF) Advantages

• Provide diversification across asset classes

• 5- or 10-year intervals to meet a variety of needs

• Generally designed to be a continuing investment for investors during retirement

• Investors do not have to buy a fund that matches their presumed retirement date (free choice to decide)

• Can buy for taxable and tax-deferred accounts (if offered as an employer plan option)

More Target Date Fund (TDF) Advantages

• Fund managers make all asset allocation decisions

• Many TDFs have low required minimum investments (e.g., $1,000 for Vanguard)

• Increasingly being offered as default option in tax-deferred employer retirement savings plans

• Offer a “low maintenance path” for investors who don’t know where to start

• Like any other mutual fund, subject to Investment Company Act of 1940 regulation (SEC)

Target Date Fund (TDF) Disadvantages

• Do not address individual risk tolerance levels

• Do not guarantee sufficient retirement income

• As with any investment, TDFs can lose money

• Sometimes (e.g., 2008) all asset classes lose value simultaneously; 2010 funds lost 30% on average

• Two layers of fees: TDF and underlying funds

• Can’t make “apples to apples” comparisons

• Extended glide paths may leave investors exposed to more risk than they want

Take-Away #5: TDFs work best for your entire retirement savings

Other Key Points • Small differences in fees can translate into large

differences in returns over time

• Consider a TDF’s asset allocation over the whole life of the fund

• Consider a TDF’s inflation protection

• Compare the % of stock at a TDF’s most aggressive and conservative investment mix

• Consider the number of underlying funds in a TDF

• Seek out TDFs with expense ratios < 0.84% (industry average)

Future TDF Projections • Expected to hold 35% of 401(k) assets by 2019;

(13.5% in 2013 according to Cerulli Associates): http://www.wsj.com/articles/fears-about-target-funds-1425870191

• Vanguard projects that, by 2016, 55% of all plan participants and 80% of new plan participants will be invested entirely in a TDF: http://www.benefitspro.com/2012/06/26/vanguard-managed-retirement-accounts-increasing-in

Target Date Fund Resources • Investment Company Institute:

http://www.ici.org/pubs/faqs/faqs_target_date

• U.S. SEC and Department of Labor: http://www.dol.gov/ebsa/pdf/TDFinvestorbulletin.pdf

• Investopedia: http://www.investopedia.com/terms/t/target-date_fund.asp and http://www.investopedia.com/articles/mutualfund/05/051005.asp

• U.S. SEC: http://www.sec.gov/investor/alerts/tdf.htm

• eXtension: http://www.extension.org/pages/63010/monthly-investment-message:-february-2012#.VQyJak0tGM8

Before You Invest in a TDF • Examine a fund’s fees

• Review a fund’s past performance

• Understand a fund’s glide path and stock % landing point; is it a “to” or “through” retirement TDF?

• Understand a fund’s strategy and its underlying assets; are they active or passive funds?

• If in a taxable account, know the minimum deposit

• Read the prospectus!

Key Take-Aways • TDFs become more conservative automatically

• Three key performance factors are fees, underlying funds, and glide paths

• Performance among TDFs can vary dramatically

• Knowing a TDF’s glide path is critical to understanding its risk profile

• TDFs work best for your entire retirement savings

– Many investors combine TDFs with other investments

Key Take-Away Applications • Decide if the simplicity and automation of TDFs is

attractive to you and/or your clients/students

• Read a TDF prospectus to understand TDF fees, composition, glide paths

• Compare the performance of at least three comparable TDFs (e.g., three 2040 funds)

• Compare the glide path of at least three comparable TDFs (e.g., three 2040 funds)

• Consider repositioning current, unfocused retirement savings into a TDF

Key Soundbite Investors should know what they are buying because not every target date fund with the same date is the same.

Question #4: Any final questions about TDFs? Put Qs in the chat box and I’ll answer them.