<p>Target Date Funds offer a one stop solution for retirement planning. Watch as three top experts discuss why investors should consider this instrument in their asset allocation strategy. </p>
<ul>
<li><p>Daniel Oldroyd - Portfolio Manager & Head of Target Date Strategies at J.P. Morgan Asset Management</p></li>
<li><p>Brad Vogt - Portfolio Manager at Capital Group (American Funds)</p></li>
<li><p>Michael Sowa - Vice President, Investment Strategy at BlackRock</p></li>
</ul>
Video Image:
Duration:
0000 - 00:54
Recorded Date:
Thursday, March 17, 2016
Transcript:
TDF MC Audio Transcript (1)
Courtney: Daniel, we’re looking at Target Date Funds, what’s the DNA of these glide paths?
Daniel Oldroyd: [0:00:04] Sure. At its heart every Target Date Fund is trying to go from a higher risk allocation to a lower risk allocation as they get closer to the target date. Every Target Date Fund is going to have a different take on what the proper rate of changes in the glide path, right, well, that’s that how it changes over time. For us it starts with the participants and getting as many participants to retirement with some minimum level of income replacement, right. So first and foremost, what is our objective? How are we going to get there? And what we try to do is to make sure that we use diversification, that we use risk capital, get some returns along the glide path. And as we get closer to retirement, start to pull those risk assets down a little bit more. So at the point of retirement we start to think a little bit more about … less about accumulation and more about what are participants going to be doing with their assets as they approach retirement? And for us it’s really a question of where are those cash flows the participants generate and how can we best create a portfolio that over time takes that into consideration and helps those participants get to retirement with some level of retirement income success.
Courtney: [0:01:24] Right. So dialing back those risk assets as the accumulation phase winds down.
Brad Vogt: [0:01:30] You know, one thing I’d say as well, target date glide paths are great vehicles. They’re relatively new but the challenge of investing for retirement and in retirement has been going on for100 years. So, people have been doing this, and advisors and shareholders who have been doing it well have been picking a sensible asset allocation given the age of the person and then investing in really strong funds. And there are things that I think sometimes the industry makes a bit more complicated about this. And really what you need are great funds in a sensible asset allocation that are rebalanced. And usually if you save enough you’re going to come out okay. And so as we constructed our glide path at American Funds first of all, we have a through glide path. We think that if someone’s 65 they have 20, 25, 30, maybe more years to go in retirement. And they need equity to keep up with inflation and healthcare and living expenses. But they need the right kind of equity. And so what we’ve done is build a glide path based on not just an equity bond mix but the right kind of equity for people of each age. And I think that makes a big difference.
Courtney: [0:02:39] And I’d love to dig in deeper a little bit later on, that right kind of equity, Michael, your take?
Michael Sowa: [0:02:44] I think Brad made a couple of really good points there. But I think as Daniel just said, every Target Date Fund provider has a different take on how they evolve over time. And one of the things all plan sponsors need to do as they start going through this process of trying to understand which is the best for them, is understand those objectives underlying each. Our view is as many have said, it’s going back to the participant, going back to some of the innate behaviors that they have and thinking about not just the investment risks as we bring that down over time, but also as Brad said, the savings aspect, it’s really twofold, it’s investments and savings. Our view is to look at that and look at how we mix that with the investment glide path on top of that, to deliver an outcome or a set of outcomes to participants, that allows them to do in the end what they want to do, which isn’t get the biggest balance over all times, it’s to spend. We all want to spend the same from the day we start working to the day we ultimately retire in the end, and that’s how we think about constructing this, which means we’ve a really big focus on downside protection and keeping participants out of those tail events.
Courtney: [0:03:50] And it seems too like downside protection is key, I mean just psychologically people are more distressed by a downside event than an equal upside event. So I think that’s got to be a consideration across the board, right?
Michael Sowa: [0:04:02] Absolutely. These are all trade-offs though, and it’s our job as asset allocators and it’s the job of the plan sponsor, the fiduciary of the plan to start weighing what some of those trade-offs are. So we think about downside protection, what that might mean. You still have to spend some risk capital to generate returns, to generate that level of retirement savings that’s going to allow you to spend over time, to use Michael’s term. And you have to trade that off versus if I take too little risk over time, am I going to get there? And what if I take too little risk and I load up a lot of fixed income assets, what is that going to do in an environment where we are like today where you might … you’re sort of at the end of a bull run in fixed income? So a lot of it is the long term view but a lot of it is the trade-offs that you want to make in terms of the possible risk that all participants are going to face over 40/50 year timeframes.
Brad Vogt: [0:05:10] We also think it’s a great point and we think it’s important that in addition to having a view from the top of the glide path, a lot of the risk balancing happens in our glide path inside, under the hood in the funds themselves. And so some glide paths in the industry have sort of what I would describe as index-like or growth equities and index-like or growth bonds. And then they try and mitigate the risk through the glide path or through alternatives. What we try and do is have equities that make sense as people age so the older they get they get lower volatility equities, higher dividend income, higher dividend growth. And that provides more risk mitigation within the equity portion, not just the amount of equity but the type of equity. And then our bond portfolio in American Funds glide path doesn’t have to stretch as much so we have a little bit less emerging markets, high yield, so it’s more stability preservation. So I think the different ways you can do this, you can have a glide path that has bonds –pedal to the metal – and equities – pedal the metal – and try and figure out the mix. Or you can have the underlying funds do some of the risk mitigation for you, which is the approach we’ve taken.
Courtney: [0:06:25] So it’s almost a bottom-up approach?
Brad Vogt: [0:06:28] Yeah, both are happening. So there’s a top down allocation based on the fund or funds and then there’s a dynamic inside the glide path risk mitigation in the shades of gray of those funds.
Michael Sowa: [0:06:42] I actually really like the way that Dan put it out, because every step of the way there’s a trade-off. And meaning one of the things to focus on are different Target Date Fund providers and the trade-offs they’re taking at each step of the way. And we can highlight with this with just a quick example, let’s look at the farthest from retirement funds and then nearest to retirement funds. When you look across the industry, probably the least dispersion we see are in those funds that are farthest from retirement. But that’s not to say they’re all the same. I think there’s a pretty wide range between 90 and a 100% equity that different Target Date Fund managers make. Our view is we take more risk at that date because when participants are youngest and they can bear the downside that might happen then, other managers are still trying to protect even those participants from levels of downside risk, that’s the trade-off managers are looking at and making. The other side of this example, the near retirement funds, probably where we have the widest dispersion of equity landing points and glide paths in the retirement industry, it’s a similar concept. How much risk do you need to take for participants at that time to deliver on your objective? And is it the right time to be taking those risks? Again just layering on our view is we think about it that point in time as one of the riskiest points in a participant’s life. So we strive with many of our other peers to get to the lowest risk point in the glide path at that point in time. Whereas others might view it as the point to take more risk to help protect against some longevity. And again it’s all about this concept of trade-off within our Target Date Fund.
Courtney: [0:08:07] And you said before, Michael, the day you retire is the riskiest day in the glide path. And that the accumulation phase is kind of, you know, you seek the lowest dispersion. How are you, I mean let’s examine to versus through, I know, Brad, you said you have a through fund, what about you?
Daniel Oldroyd: [0:08:25] I think it’s a great question. I think it’s a fun term, it rhymes, right. That said I would argue that to versus through can lead to some overly simplified conversations. If you take the most conservative glide path, the one that has the heaviest amount of fixed income in the industry and you take the most aggressive glide path, the one that has the heaviest amount of equity in the industry, those are both through funds. But I might argue that what you really want to get at in the design of a Target Date Fund and as you have conversations with your provider is what is the objective and what is the priority of that Target Date Fund manager? So for us, while we have a glide path that technically is a to glide path, we don’t make any changes at the point of retirement, very similar, we’re worried about preserving some optionality on behalf of our participants. We’re also trying to make sure that that portfolio is something you can live off of for quite some time, right. So we’re not willing to sort of throw out the longevity portion of the equation. We also want to make sure that that portfolio has some sort of real asset flavor to it, so we can protect the purchasing power. So for us it’s trying to balance out those competing priorities that many asset allocators face. And if we stick to to and through you kind of can confuse the issue sometimes. And in mass what is a Target Date Fund manager trying to do for you? And how does that match with your plan? And that’s the, I think another really interesting conversation we have with our part sponsor clients is who are we building these for, and going into detail about the overall plan design. Where does the Target Date Fund fit in against the pension plan, if there is a pension plan or if it’s only a DCS as the retirement asset?
Brad Vogt: [0:10:22] You know, one thing on this I think Michael and Dan make great points about is “to” vs. “through”. And I think there’s probably more made of that – those terms – than is needed. But there’s also, you really have to look under the hood and look at what are these equities and what are these bonds? So for example we have a through glide path, we manage it all the way through 90 years old. And it does have more equity at retirement than most glide paths. But if you look at what those equities are, the predominant equities at that age in our glide path are funds like Capital Income Builder, Income Fund of America. So while they’re higher equity from a simplistic level, they’re actually creating the right balance of risk and return, longevity risk and market risk. And what we’ve seen interestingly is that the 65-year-old’s portfolio in our through glide path often performs better in sort of a risk-adjusted situation versus some to glide paths, even though it has higher equity, because its equities are much less volatile and higher income, and because of that, the bond portfolio can be more-stability preservation oriented. So you really have to look under the hood and get past the simplistic, whatever, stock, bonds and understand what are you really owning, because the participant is going to own those funds. The participant owns the funds, not the asset allocation.
Courtney: [0:11:52] So more focus in the later years on the dividend payers, especially and you brought up the point of the erosion of purchasing power because of inflation, it’s such a big point that I think everyone who’s at or approaching retirement is thinking about.
Michael Sowa: [0:12:08] I actually completely agree with Brad. One of the most important things you can do every step of the way is understand the fundamental risks, not just from the equity fixed income glide path perspective, but from the underlying assets and even the composition of the assets themselves. Another example to your point, not on the equity side but on the fixed income side, many peers use high yield, which can be a great investment to use, whether from an active sense or even from a passive sense. But when you compare that to a peer that doesn’t use high yield, you might be skewing or misrepresenting what the risk allocation of that fund is, so understanding what you’re investing in. Going back to to versus through to Dan’s point, it’s a very old industry parlance we’ve become accustomed to and we can’t shake as much as we’d like to try at this point. And it doesn’t do what we’re all trying to accomplish justice, there are downward sloping Target Date Funds who are designed to terminate at a point where they expect participants to leave. There are flat Target Date Funds post retirement that are designed to provide an optimal balance of allocations to manage longevity risk, inflation risk and market risk for participants. So just to say that they’re to versus through doesn’t really help solve the problem, to Dan’s point, we need to think about the objectives that they’re trying to achieve.
Brad Vogt: [0:13:24] The thing that’s interesting though is, I totally agree, demographically, I mean I saw a statistic the other day that, you know, 90 is the new 80. But there are two million 90-year-olds in the United States; that’s tripled in the last couple of decades. The Census Bureau thinks it’s going to quadruple. So you know, people haven’t saved enough, Social Security’s not going to be there, bonds are at 2%. If you’re at 65 and you’re going to have a 30-year retirement and you want to keep up and you maybe want to help your grandkids go to college and leave something for people, not just spend it all, you can’t just have a flat line ultraconservative glide path. It’s not responsible. So you need to be investing in the right kind of equities that have enough yield and dividend growth that help you keep pace with inflation. The bond coupons don’t grow, that’s one thing we know for sure. So the great thing about actively managed and selected dividend growth funds is that you have that offset to inflation. And it’s a long time, 30 years of retirement, and it’ll probably go up from there.
Michael Sowa: [0:14:34] What’s funny is we actually take the opposite approach. So you can imagine the conversations we have with our clients. We use high yield fixed income as a way to bridge the gap between equities and fixed income. We don’t, in our portfolio construction think of it as fixed income, it’s a return seeking asset, it happens to have lower volatilities than a lot of equities. It also is key that it’s an area we want to be very actively managed. We don’t want to be buying the index, case in point; any exposure to an energy company these days in a high yield fund is going to be disastrous. But we’ll use that rather than use the equity portion of the glide path to bring down risk as we’ll hold less … what we’ll do is we’ll hold less equities and buy a little bit more credit, buy a little bit more high yield to help us manage the overall volatility. So in terms of thinking about what are the different pieces we can use, we’ve elected not to go with dividend oriented equities because we feel like the volatility, the possible spread is higher than a fixed income high yield fund. So we want to make sure that we’re measured in the way we build this in. And that’s how we’re going to approach sort of pulling down the risk. But you can see two very different approaches. I think we’ve both done a nice job actually of producing for our clients and our investors. But we’re definitely taking different paths to get there.
Courtney: [0:16:11] Yeah. And then how important is active management? I mean when you’re talking about for instance, high yield’s so important to look at energy and materials and potentially avoid many if not all of those credits. And the same for you, you mentioned active management as well, how do you look at active versus passive funds and where’s the appropriate place when thinking about fees and risk and all the factors that factor into it about where in the glide path, where in the risk appetite you want to use active versus passive?
Brad Vogt: [0:16:41] Well, at American Funds we’re all active; we have been our whole history. We’ve been around for 80 years; this is all we’ve ever done. We believe that and we’ve had great long-term results, And we’re in Morningstar Fantastic 50; we have 11 of the funds. So we’re committed to that. We also think it makes sense for a retirement challenge which starts at maybe aged 25 and goes till 95. So you want to be able to be in cash at the portfolio manager level at times when the market’s overheated. You want to be able to have funds that don’t mimic the index, that have specific objectives that are built for retirement, maybe there’s an eligible list to higher dividend yield on the fund so it cuts out some of the risk of that fund. You can’t do that passively. If you’re looking for – take our two high equity income funds – Capital Income Builder, Income Fund America; those are global funds. You have to be global to look for high quality blue chip dividend stocks. The S&P only yields 2%; Australia, Canada, the UK, Switzerland, Germany, all yield significantly more than that. So you have to have a global perspective; you have to have funds that have built in risk mitigation. And you really need to be knocking on the doors of these companies and doing your own research, because if a stock is at a 5% yield, you know, you need to know whether you think it’s going to keep that dividend or not, or grow the dividend. And so we’ve always taken the active approach to the underlying funds. And then I think all of us essentially have active decisions at the glide path level. So there is no purely passive glide path because you’re … even the ones that are built on passive index funds, you’re choosing to have a glide path asset allocation.
Courtney: [0:18:35] It’s inherently active.
Michael Sowa: [0:18:36] And that’s what I was going to say, first and foremost there is no passive Target Date Fund. All Target Date Fund managers make some choice along strategic asset allocation lines. The question beyond that becomes, once you have that broad strategic asset allocation that lines up with your objective, do you want to take the active or passive implementation? And there are benefits to both. And I don’t think there’s necessarily an agreement across the investment world towards one. You look at DB plans, there are active and passive DB plans. And there are active and passive Target Date Funds. It becomes then a decision that the plan sponsor needs to think about, the plan sponsor needs to make and weigh the trade-offs of both. Passive investing can be brought to you very efficiently, very cheaply, and achieve goals that are in line with the market and deliver to the objective of the client, of the end participant. Active management can bring that additional return; can bring maybe some additional risk mitigation to it. But it also brings that risk of active management itself. When you make that choice, you as a plan sponsor have to own that and understand that it can impact your participants. It can impact your participants to the positive. If you have a series of great returns, and there’s lots of good active managers out there, it means your participants can save less. It means they can long term spend more and in the end spend more. But if that active manager fails, you’ve done the opposite for your participants.
So as long as the plan sponsor is going and think about the trade-offs, and we support all three decisions, we actually have active, blend and fully passive products on our lineup, that’s the thing what makes the most sense. And when then comes to active management it does come back to a lot of what Brad was talking about. You need to understand the risks of your own active managers, make sure you’re not just buying the same style, the same bets. You need to have a risk platform that can accomplish that on the top … at the bottom of the level.
Courtney: [0:20:25] Well, what risks do you think are the most impactful to participants, Michael?
Michael Sowa: [0:20:30] So to participants, it’s really four predominant risks that they face every day. They can turn on the TV and see the market risks, the fluctuations up and down of what we experience, that the talking heads talk about. You can also then think about long term investment related risk, and this is inflation, this is one where we don’t necessarily think about it every day. But a dollar cup of coffee would have cost probably 16 cents when a retiree today started working. How do you protect them from that purchasing power cut? How do you protect them and keep their ability to spend at the same level over time? Then there’s longevity risk, I think the way we oftentimes frame this as will I run out of money or will my money last? And that’s one that’s also constantly evolving; increases in benefits and health are making us live longer. I think the common statistic is the first person to live to 150 is alive today. But I think that’s a bit of a stretch. We do see these advancements making people live longer. I think earlier we just mentioned that, the new 80 is the new 90. So that is something we are dealing with today. And then lastly what I think, and we view at BlackRock, one of the biggest risks to participants is themselves. It’s the ability to make the wrong decision at the wrong time that can actually significantly impact their ability to have a stable set out of outcomes in the end.
An example of that is just look right now at Morningstar information that compares the average fund return versus the average investor’s return. There is a 2½% different annualized over 10 years between the average investor which is the participant we’re all trying to work for, and where our funds on average are producing and putting out the market. That’s the biggest risk which we really need to think about and overcome and Target Date design is one aspect of that. But there’s also a lot that goes into it.
Brad Vogt: [0:22:23] You mentioned fees and I think those are critical. And in time you have something that is eating away your return for decades. You have to pay a lot of attention to it. You have to look under the hood, and it’s not just … it’s not just the fee itself; it’s what return are you getting for that fee? So you can choose to have a passive index fund and it will have a low fee, but it should. , It’s guaranteed to have mediocre results; it’s guaranteed to never do better than the average in terms of reducing volatility. That’s what you’re going to get; it’s always going to have big holdings in the area of the market that’s gone up the most recently. And you know, I think back to the … I used to follow the Telecom area; in the TMT bubble, the S&P was 32% in tech and telecom. And that’s what you owned. If the glide paths were around then and had much more assets, everyone in the index funds would own that. So I think fees have to be looked at in terms of the return you get for the fee, and also the risk-adjusted return. And I totally agree with Michael’s point that the most important thing is saving enough and having the company match you; that’s more important than anything we’re going to talk about here today. But you really do have to focus on fees and see what you get for the fee you’re paying.
Courtney: [0:23:42] And when you talk about risk adjusted return too, I mean if you think about okay, if you’re weighing active versus passive on the fees, maybe it’s 75 basis points more to go into active hypothetically. But let’s say then your risk adjusted return would be 300 basis points more, of course you can’t guarantee that, but let’s just say hypothetically those were the numbers. How much of a challenge is that in discussing that with fiduciaries?
Daniel Oldroyd: [0:24:08] Where we start really when we think about this, I think that the danger in weighing fees as a primary motivation is that has a tendency to drive the asset allocation. For us we use active, we use passive, we have fully active series, we have a blended series, they have the same glide path for a reason, because that glide path, those betas is going to be what drives us and how we think about modeling. If we started with the fees, I can’t help but start with the US equity market and US fixed income market because they’re the largest most liquid markets in the world. So I’m going to have a glide path with a big emphasis on that whether I like it or not. So for us and what we try to educate our clients on is start with the glide path and you could find the glide path that matches to your sort of implementation budget. And if you have the appetite to go for that … that 300 basis points excess return, go for it. More often than not you’re seeing clients, who choose an approach that’s a little bit of both, or you know a little bit closer to say, you know, that 50 basis point fee target or that 25 basis point fee target. But in terms of is it the be all and end all? We’d highly recommend people sort of start with the glide path first then get into the fees. And I think it is fair to sort of ask yourselves has this manager or managers generated the fee or are they worth the fees that we are paying them? And hopefully it’s an excess of whatever benchmarks we’re going to put out for you to judge us by in terms of success.
Michael Sowa: [0:25:53] Courtney, first I’m going to say, if you can increase my risk adjusted return [inaudible] by 300 basis points for only 75 basis points, you’re probably better off out away from behind the desk. But we’ll just stop there and I’d say I completely agree with Dan. It shouldn’t be a conversation with here’s what I want to pay, what can I get, because if that’s what we’re going to do, we’re going to end up in an industry where Target Date Funds are all a glide path with just S&P 500 and the Agg, which we can do very cheaply and there are some arguments they maybe they’ll still deliver. But you’re going to miss out on a lot of other benefits that Target Date Funds actively or passively managed can bring. Because again, even passively managed Target Date Funds are making active strategic asset allocation decisions. Those decisions help with risk management. Those decisions help participants get better returns on a risk adjusted and an absolute return level. And those Target Date Funds overall are geared always to delivering on the objective in the best way they can and most efficient vehicle.
Courtney: [0:26:53] What about, you mentioned correlations too, how much of a challenge is it to find non-correlated assets? You mentioned going international, how else are you guys doing that?
Brad Vogt: [0:27:03] Well, we have very broad diversified funds at American Funds. So we have – and as I said, we have a spectrum even within our equity and bond portions of our glide path – we use 17 equity funds across the whole glide path, some are more capital appreciation growth-oriented. They’ll have a fair amount of correlation with the ones that are more growth and income middle of the market, and less correlation with our high equity-income dividend-growth funds. So we have a spectrum within and the same with our bond funds. We’ve felt like with alternatives, it’s kind of an interesting topic. You know, the way I think about it is you’ve got this car and you’re on this journey. And there are a couple of ways you can mitigate bad things happening on the journey. You could have the core engine of the car have the pedal to the floor and then you could put on all these counter measures, you know, rear spoiler or those little fences on top of the headlights, in case something bad happened. Or what we try and do is drive the car at the right speed, given what road you’re on, and then you really just need a seatbelt and some airbags. And you need sort of tried-and-true things that are risk mitigation and are uncorrelated like cash. So you let the active managers of actively managed funds hold some cash when the market’s overheated, or some things like TIPs or Treasury bonds which are very liquid, very cheap and likely to do well in terms of not being correlated to the equities.
We feel like the trade-off of commodity funds, real estate partnerships, private equity, funds of hedge funds, the cost benefit analysis that we’ve done on that, it doesn’t really add up. You’re not always guaranteed that you’re going to be uncorrelated with equity markets. They’re expensive, sometimes opaque, and sometimes you can’t get out. So we have not used those type of alternatives.
Daniel Oldroyd: [0:29:04] So what’s interesting when you think about the correlation question, all correlations go to one, that sort of becomes the big question. And the trap everyone fell into in the middle of the first part of this century, right, 2005, 2006, 2007, was that of course this stuff is diversifying, let’s take it out of fixed income because it’s diversifying and it’s returning enhancing, so let’s bump up our volatility for portfolios because the correlations are less than one. And that’s what got everyone into trouble, right. You saw lots of asset allocation vehicles go higher and higher volatility in terms of their mix of risk assets. But at the same time if you just simply kept a 60/40 allocation and kept that constant and then out of your equities funded some of these diversifying asset classes you would have been in good shape. So it’s about how you think about the overall portfolio risk in context of the market and what that might give you.
Michael Sowa: [0:30:10] And I would agree. We definitely still need to think about this in terms of the overall portfolio risk. But when I think about the correlation question, I think about the advances we’re making in the investment field. More and more asset classes are becoming available to us almost every year. And then the question of, well, if we want to build a diversified portfolio, don’t we need to put that in somehow? And I think there are great strides you can make by adding asset classes that are diversifying and show that their correlations are different. But we also need to avoid the trap of diversifying in name sake only, not actually going the distance of understanding, do these assets actually create a material benefit or are we forgetting about the operational complexities because we can then go and put in asset classes just from a theoretical basis only, but operationally the complexity can be much more difficult to bring apart. And I guess to bring that alive to a bit is one thing we always talk about is global fixed income. Global fixed income can be diversifying; there might be some problems within global fixed income in terms of concentrations, particularly around Japan. But overall they do bring rate diversification in, in a more divergent world among central banks that can be a benefit. But when you then look at the numbers, and this is one aspect our team has done a lot with, we find that on an unhedged basis when you’re buying global fixed income, you’re really just buying a lot of currency risk. And there’s nothing wrong with currency risk if you have views on that. But that can then lead to another aspect of active management. So again back to the trade-offs, does that active management make sense?
Courtney: [0:31:41] Because you’re paying to hedge out the currency risk?
Michael Sowa: [0:31:43] You’re either paying to hedge out the currency risk, but that’s actually more of a passive decision. You might be paying to hedge very specific currency risks and then buy more of other currencies, where you feel there might be a long term appreciation or even short term appreciation. Active managers typically need to be compensated for that. But let’s actually go back to your question, what if we were just to hedge out all of the currencies and take it to a fully unhedged or a fully hedged benchmark, more of a passive implementation there. Well, that is a cost and there is implementation and operational hurdles around that. So while we view, yes, there could be a benefit from an investment theory perspective of adding global fixed income into our portfolios. When we find that we go through the next step and the problem is let’s actually implement this, those costs and those hurdles become one that didn’t make sense to us and actually brought the portfolio back to essentially a coin flip in terms of performance. And our view was, let’s not overcomplicate the portfolio when our view is it’s a coin flip at this point. But that’s also not to say it’s something that won’t change and evolve over time. I think all active managers need to relook at their asset allocations, second guess themselves and say, “Well, that wasn’t what we saw then, this is what we saw now and be happy to make those changes to be the best for participants.
Courtney: [0:32:56] What are some of the best practices in terms of plan design to help, you know, create the best outcomes?
Daniel Oldroyd: [0:33:02] Sure. We talked a little bit earlier about the importance of savings. And the role a Target Date Fund has in helping a participant save is that we keep you invested and we keep you from moving in and out of the marketplace. So with that you see lots of plans adopting automatic enrolment, right, get people into the plan. You see plans more and more going towards automatic escalation. And that’s key. The downside of automatic enrolment is that your contribution rates actually start to tail off. So I might have joined the plan and signed up at 5% but I’m automatically enrolled at 3. So there is a couple of years of sort of having to catch up. And not everyone does automatic escalation. I think a lot of large plans do it, but the broader industry is still sort of following themselves up.
Courtney: [0:34:00] Why do they not do it?
Daniel Oldroyd: [0:34:02] If you think about the size of a plan and a smaller plan versus the size of the company’s operations and that’s real cash flow, that’s real assets and real dollars, they have to spend. So you see things actually like automatic escalation but pulling people up and using being creative the way they do the match. So instead of, you know, everyone typically does dollar for dollar on the first 3% or 50 cents on the dollar for the first 3%, maybe do a quarter of the 10%. And that pulls people in for the same dollar amount. And the last one is automatic enrolment. Sorry, the last thing that the plan sponsors can do is a re-enrolment or a re-fault, is the other term that’s being used more and more. And that’s putting the entire plan into the qualified default investment alternative and allowing people to opt out. And what that does is it gets more people into the diversified portfolio, it captures the natural inertia that a lot of participants have, a lot of participants are anxious about investing; they want someone to do it for them. But to take that step and to make that change, what we have to remember is the Pension Protection Act’s only 10 years old. So it’s 10 years worth of people being defaulted in. But what happens to every participant who joined the plan from 2006 and before, or even before the default that was implemented, so we hear lots and lots of questions about re-faults, re-enrolments, how do we get more of our participant base into the default investments so that they can stay on that savings path.
And for a plan sponsor it creates some certainty, right, if they follow this path and they contribute then more of my participants who do that I can sleep better at night knowing that in 20/30/40 years, there’s a higher probability that they’ve hit a minimum level of income replacement. As opposed to, okay, well, someone’s in the small cap fund and hopefully, you know, they retire at the right moment.
Brad Vogt: [0:36:06] You know, it’s really – I just think it’s so great how much progress the industry has made. To Dan’s point; it’s only been 10 years. But whether you like JP Morgan or American Funds or BlackRock, all of these are better options than company stock or cash or the small-cap growth fund at aged 58. So a trillion dollars has gone into vehicles which really are sensible and I think that’s a good story that will continue. We need all the glide paths to do a great job for workers. I think another area that is evolving, at the beginning of the target date industry, I think it was easy for a plan sponsor to pick a recordkeeper and then just take the glide path of the recordkeeper. And after 10 or 15 years of experience with that, I think a lot of plan sponsor advisors are reassessing. It’s really two decisions. You have a recordkeeper relationship and then you have who do you want to manage your employee’s life savings for a long, long time? And those can be two different entities, two different people; they could be the same. But I think more people are looking at it as two important decisions as opposed to one. And that’s healthy for the industry, and I think that will continue to gain traction.
Courtney: [0:37:16] So you think that we’ll see continued growth, I mean especially with that divergence of where it used to be the record keeper was both the record keeper and the provider, whereas now everybody’s an expert, the record keeper is the expert in doing record keeping. And then you hire a manager to be the expert in creating the correct glide path?
Brad Vogt: [0:37:33] They’re both critical functions and there are lots of people who do them well. And there can be situations where it should be the same person. But I think people are looking at it as two important decisions. And that’s really healthier than the early innings of the industry.
Michael Sowa: [0:37:48] Dan brought up a lot of great tools that we can use to help participants, guide them along the path. But I think one of the things we’re talking about is why aren’t we seeing more prolific use of these tools, auto enrolment, auto escalation, re-enrolment, matches, and then why aren’t we seeing plan sponsors being more forward in terms of actually guiding or nudging their participants along a better path? I think one of those is cost and Dan did mention that. But I think the other is it’s very subjective. It’s hard to take that concepts and theory and then make dollars and cents out of it, actually translate it into something where here is a quantifiable benefit we can see happening to participants. But another advent that we’re seeing a lot of is development of new tools and plan design analysis to help plan sponsors understand their employees and develop it further.
The other aspect of that is also tools to help people understand where is the spread of their participants. And I think we’ve probably all seen these charts which show here’s a reasonable allocation. And then here are all your participants and it’s just a scatter of dots everywhere. We would hope that would be a bit more compressed and understand that people can make decisions on their own. But it’s really telling us that most individuals may not have a good handle on where they should be invested from a right perspective.
Brad Vogt: [0:40:02] And that’s the beauty of the re-enroll that Dan talked about. And I think again, they’re early innings now; we’ve got companies sort of reassessing, not only reassessing who is the underlying glide path investment manager as opposed to the recordkeeper, but when they do that, taking the opportunity to re-enroll. And that’s so healthy because then the scatter plot becomes much tighter in terms of what people are doing on their asset allocation.
Daniel Oldroyd: [0:40:26] Yeah. You’re really going back to getting more controlled outcomes [inaudible] the DB plan of yesteryear, right. And anything you can do to replicate that, given the framework and where we are in today’s retirement world is a good thing.
Courtney: [0:40:41] We hear about the DB-ization of DC plans, I mean is that sort of what you’re talking about?
Daniel Oldroyd: [0:40:47] Yes, precisely. So what a DB plan was is guaranteed income or an income stream, as close to guaranteed as possible. And that you knew as a participant, I worked for so many years and I had this final [inaudible] salary and I have a formula and I will get this. So to the extent that you can get more people in a diversified portfolio, get more people funding that diversified portfolio as a plan sponsor you know you’ve fulfilled your fiduciary duty to get those participants to retirement, and to maintain a standard of living that’s acceptable and provides comfort in their waiting years.
Brad Vogt: [0:41:31] The one thing I would add to that, I think just like with the glide paths today you really have to look under the hood of the DB plans. Because we talk about DB as if it’s monolithic, historically and today there are a full range of DB plans, some that I would say are sensible, practical, hire great long-term managers; don’t add in a lot of high cost, fancy stuff. And then other DB plans which are massively tactical, lots of sort of risky hedge funds that don’t have any track record. So I think if we can take the best of the DB approach to participant education, to basic asset allocation, but then have them in really sensible funds with, you know, good results, good fees, and a reasonable asset allocation, we’ll get the best of DB without the downsides of some DB plans.
Michael Sowa: [0:42:24] And that’s what the 401(k) industry I think has been doing over the past 10 years. We’ve really made huge strides in being able to provide better investment solutions to participants, better communications now, better apps. But I think one of the areas that we still haven’t necessarily fully overcome is that final step in DB-ization which is income. There has been lots of talk, there has been new regulations that have come out about it and there’s been more and more demand. I think there has been some surveys that have come out recently that talk more about individuals and participants wanting that type of solution. If you actually go and look at the survey and we were talking about this earlier, people think Target Date Funds provide guaranteed income, but they don’t, that’s obviously demand. So that’s really the next step and I think that’s what we are still working towards, whether it’s through portfolios that can mimic income producing funds or an actual dump into an annuity product that allows participants exactly what they want, which is just the paycheck that they can use. I think that’s where we’ll be likely seeing things evolve and go forward. And because we’ve done so much in the investment solution sides and the communication that’s really the last frontier.
Courtney: [0:43:34] And to your point, we saw the largest pension in the world in the state of California … in the US in California completely divest out of hedge funds, so that’s interesting to your point. Going back to behavioral aspects, what are kind of the most important behavioral aspects and is at the participant or the fiduciary level that you’re looking at them, Michael?
Michael Sowa: [0:43:53] I think they’re at both. At the participant level it’s understanding how your participants are using not only your Target Date Fund, but all the funds in your lineup. And at the plan sponsor level it’s providing that strong investment solution or strong investment plan lineup. So there’s behavioral aspects on both, that need to be thought about. It’s one that involves you going more and doing the research and actually looking at all the different aspects of a Target Date Fund.” And so that’s why I think there’s behavioral biases on both that need to be accounted for. I think we’re probably better off addressing the plan sponsors, the participants we don’t necessarily have as much of the direct reach out yet.
Daniel Oldroyd: [0:44:51] I might argue on the participant side, one of the things the participants do, right, their end of the bargain is the savings, right, can they continue to contribute. That’s critical to understand. So, in thinking about what is that, that is cash flows, cash flows into the portfolios, cash flows out of the portfolios. So from a very tactical asset allocation design, I want to understand that. I want to understand when are they more likely to take withdrawals from the K plan, when are they more likely to take loans? And so there’s things that we want to understand and we encourage our plan sponsors, here are the questions you should be asking your record keeper to understand what are people doing at retirement. Are they staying in the plan? Are they leaving the plan? How is your Target Date Fund manager addressing that, if at all? And what we’ve found is it’s a very powerful way to understand what a reasonable objective is for both the plan and the Target Date Fund manager.
Courtney: [0:45:49] Well, when are they taking kind of withdrawals, is it because they have a life event that creates that need or is it because you mentioned the talking heads on TV, and that it’s just creating panic and inopportune selling?
Daniel Oldroyd: [0:46:00] So we’ve actually studied this for 15 years now. And what we’ve found is the withdrawals will happen all, 20s, 30s, 40s, 50s, and that’s what I call life happens, right, loans. Why do people take loans? Well, because they need to make a mortgage payment or something happened, you know, had a storm several years ago and a tree fell on my house, I need to replace the roof. And it was a very easy way for me to get some quick money and replace it. The other place that withdrawals do start to happen is at 59½ and that’s when tax penalties go away. So you do have people starting to think about retirement and the lifecycle tends to be, okay, I’m going to just contribute to my 401(k) plan, not think about it, probably not even look at my investments, and I get into my 30s, my 40s and my 50s and, I’m going to retire in 10 years, let me start thinking about it. So that’s one of sort of my personal theories that we think some of the evidence suggests is people start to engage more as they get closer to retirement. They may or may not be taking withdrawals because they’re going to be doing something interesting with the money, they may be taking it because they want to start a second business in retirement. But they are doing so many different things, accumulation, everyone’s very similar, a decumulation, retirement spending, we all have very different plans. So that sort of bears out in some of the research that we’ve seen in the design of Target Date Funds.
Courtney: [0:47:29] Okay. And what about benchmarking Target Date Funds, is there a good way that people can evaluate different glide paths in Target Date Funds, Michael?
Michael Sowa: [0:47:37] We talked about earlier how every Target Date Fund has its own glide path. So to just then benchmark us against the average of those glide paths, while might sound great, it doesn’t actually account for the fact that the glide path you chose might have a materially different objective than all those others. A good example of that is a glide path that’s much more focused on capital appreciation over downside protection is going to run up when the market’s doing well, versus a Target Date Fund that’s more geared towards downside protection, will still participate in the up-market, maybe a bit of a lag. But what they’re going to do on the downside, significantly protect participants from those shortfalls. And so to compare broadly against that, it makes it very difficult. What we think becomes more and more important is thinking about benchmarking, not just your Target Date Fund but your overall plan in terms of the outcomes that it’s designed to produce, tracking it against are you actually helping participants narrow their gap between what they desire from an income replacement ratio to where they are. What can be done with the investment vehicle as well as with the other aspects of your plan, because Target Date Funds don’t stand alone. You can’t necessarily use them to invest outside of a savings problem.
You still need both together to really deliver on outcomes. And then it’s working with the plan sponsor that you’ve picked in terms of just understanding the Target Date Fund itself, is it performing in line with how they expect it to? Have there been meaningful performance issues, whether it’s on the passive or active side that need to be thought about and need to be addressed?
Brad Vogt: [0:49:18] I agree with Michael’s points. The one thing I’d add is just to encourage plan sponsors and advisors to also look at risk-adjusted returns, Sharpe ratio, not just the raw returns. Because really that gets to the DNA of the glide path, you know, how much risk are you taking for the return that you’re getting, and measuring that over long periods of time in addition to measuring returns over long periods of time is really important. When you have a glide path that for most of these employees it’s their whole wealth and it’s a long period of time, it’s not just the raw return, risk-adjusted returns are key.
Courtney: [0:49:55] Well, Brad in your experience how many … can plan participants push through a Sharpe or a Sortino ratio?
Brad Vogt: [0:50:00] It’s hard; they are sort of opaque. I think that the plan sponsors can do that and I think they can do a better job publishing and educating employees about what that means.
Courtney: [0:50:11] So they distill it at the participant level?
Brad Vogt: [0:50:14] Right. I think that’s the simplest way.
Daniel Oldroyd: [0:50:16] I would just make one quick point here which is traditionally if you went to a 401(k) committee meeting, you had a sheet of paper and it was fund, benchmark performance and a peer group. And you went down the list and you could sort of put eyeglasses or a stop sign or something like that and flag the underperformance and that was the lion’s share of the conversation on investments. What the Target Date Funds, what you’re seeing more and more is most of the conversation, the investment review focuses on the Target Date Fund, it’s usually the largest portion of the plan nowadays, and use a combination of things, like performance versus benchmarks if you’re active, peer groups, objective. To Michael’s point, are you a capital appreciation longevity oriented manager versus someone trying to protect on the downside. And what we’re seeing is trustees, investment committee members, and advisors, consultants spend most of their time on the Target Date Fund, and that’s a good thing.
Courtney: [0:51:13] Alright, well, before I let you go I’d love to hear everyone’s final takeaways on Target Date Funds and let’s start with you Michael.
Michael Sowa: [0:51:20] And I think I’ve said this before in these, Target Date Funds are really fantastic vehicles. They are the preeminent investment vehicle that blends both investment knowhow and behavioral insights together to provide solutions that are more than just return and more than just risk focused. But focused on outcomes for participants and the more we can continue to refine and improve the industry’s use of Target Date Funds, the better we will get overall in terms of helping support generally the participants in terms of building up their own outcomes and their own portfolios and their own lifestyle.
Courtney: [0:51:54] Right, Brad.
Brad Vogt: [0:51:54] To wrap up, I’d echo Michael and his point about we’ve made a ton of progress. Target date programs are great vehicles for investors. You really want to look under the hood and it’s critical to look at what are the funds that are … the underlying funds in the glide path, not just the asset allocation. You want to look at the quality of those funds; have they weathered cycles? Do they have time-tested returns? Who’s the organization that’s managing those funds, because that’s really what the investor owns are the underlying funds. So I think all of us have fairly similar glide paths at a high level and really the differences are in the approach of the underlying funds.
Daniel Oldroyd: [0:52:43] The best is sort of yet to come on the Target side or sort of early innings, they’ve really only hit their stride in the last five/six years. I would go back to understand the participant, understand who you’re designing these for, understand as a fiduciary who your employees are and how they might relate to the Target Date Funds. And then understand what is the Target Date Funds managers, what is their main objective when they design the portfolios and does that correspond to what you’re trying to achieve as an organization.
Courtney: [0:53:15] Such an interesting point. I mean imagine that the plan design for Apple versus Caterpillar.
Daniel Oldroyd: [0:53:20] Very different.
Courtney: [0:53:21] Well, thank you so much gentlemen, really appreciate it. And we want to continue this conversation about Target Date Funds. Follow us on our social media on LinkedIn, Twitter and Instagram. From our studios in New York, I’m Courtney Woodworth.
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American Funds investment professionals actively manage the Target Date Fund's portfolio, moving it from a more growth-oriented strategy to a more income-oriented focus as the fund gets closer to its target date.
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