Episode 16: The Basics of Target Date Funds

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Welcome to Revamping Retirement.

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A podcast brought to you by CAPTRUST Retirement Group, where we tackle the retirement plan related issues plaguing fiduciaries and plan sponsors. Our host, Mike Webb, has more than 25 years of experience in the retirement plan industry and is a nationally recognized subject matter expert. We hope you enjoy Revamping Retirement. Thanks, Karen—Karen McCauley, as always, our wonderful producer. Hello out there, everyone in Podcast Land. Hope you’re staying safe and healthy. My name is Mike Webb.

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And this is Revamping Retirement and in this month’s topic, “Target Date Funds for Dummies,” with apologies to the For Dummies authors of the For Dummies series of books. It’s in no way meant to be disparaging. No, I am not talking down to my podcast audience. I love each and every one of you. Please keep tuning in. But what I’m kind of getting here that is I think if you give a quiz to everybody about target date funds, I think you’d find that a shocking number of people don’t know the basics. think people

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kind of think they know. There’s all this kind of advisor speak out there. We talk about glide path and down capture and I think when we end up doing advisors, I’ll be the first to admit it is that we confuse participants and plan sponsors about target date funds. And they’re a wonderful thing and people should really understand them and how they work especially during a global pandemic. So I think this will be a very informative and again dare I say fun

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exploration into target date funds but before we get started our trivia question as always back in 2008 8.8 percent of retirement plan assets weren’t invested in target date funds i mean you may be saying is that all really only 8.8 back in 2008 well in 2018 what do you think

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the percentage of all retirement plan assets invested in target date funds was? So I’ll give you it’s higher than 8.8 and I’ll even give you a credit if you get within five percentage points of this answer. So again, that’s our trivia question. 2018, what are the percentage of all retirement plan assets invested in target date funds? We’ll get back to that end of our 10 minutes or so, but let’s dive right into our topic. Shall we? I always like to define things when we’re going over the basics of something. So we’ll use the definition from Investopedia. Investopedia is good for some things and not good

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I think this is a pretty good definition. A target date fund, or what we in the biz like to call a TDF, because we like using acronyms for just about everything. TDF is a fund offered by an investment company that seeks to grow assets over a specified period.

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So that’s fairly simple. I’m trying to grow assets over 10, 20, 30, 40 years. The structuring of these funds addresses an investor’s capital needs, what kind of money I need at some future date. Hence the name target date. So that’s the target date. Another common name for them is life cycle funds, meaning the funds are designed for growth at various stages of your life cycle. For example, a target date 2020 fund,

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is designed to meet my retirement needs if I retire in, Come on out there—I know you know the answer—2020. Yay! I haven’t put you to sleep yet, so that’s good. So there’s our basic definition. Now, there’s generally two types of targeted funds, there are technically more, but I think for our purpose, our discussion, we’re going to focus on the two types. One is the off-the-shelf type, which is found in most plans, and they’re composed of investments selected by the particular investment provider.

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that may or may not be investments that exist in the retirement plan. And they may be the provider’s own proprietary investments. They may be a mix of outside and proprietary investments. Proprietary, by the way, I mean, means invest in the same company. So if you have a Vanguard retirement fund, the underlying funds would be Vanguard funds. Well, I guess it could be outside funds or it could be a mix. So that’s one type, and that’s the dominant type out there today.

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Something you see in some larger plans are what are called customized target date funds. for lack of a better term, I’ll call them target date plus funds. And the plus part of it is…

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First of all, they generally take the funds already offered in the existing retirement plan with certain exceptions. And they might also, again, be a mix of existing retirement plan funds because a retirement plan might not cover all the asset classes so that they would take some funds from outside funds for other asset classes. But usually start with the retirement plan core array as a starting point, which kind of makes sense because the fiduciaries of a plan obviously have prudently selected those core assets. So why not use those investments in the target aid fund rather than an off-the-shelf product? And also, they may have other features customized to a particular

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plan sponsor as well. For example, it might be customized to a particular demographics of the plan sponsor. A good example, this is retirement income options. If I’ve got plan demographics specifically suited to decumulation, I’ve got a lot of baby boomers, a lot of people coming into retirement. I probably more than likely in a customized target aid fund to actually have a decumulation strategy where we’re annuitizing or at least providing some sort of fixed benefit out of some of that income.

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as part of the target date fund when we’re accumulating assets. I should also probably talk a little bit about managed accounts because people kind of don’t realize that managed accounts are kind of like the super supercharged target date fund in a lot of ways. You pay more money for them generally but what they do though they’re not technically target date funds they’re just taking the same concept and actually customizing

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the target dating approach to the particular demographics of an individual participant. So they’ll take all kinds of data about the individual participant and use that to customize Target Day Fund basically for them. They don’t call it Target Day Funds, call it Magic Counts, but it is the kind of the ultimate Target Day Fund, if you will. What else can I tell you about Target Day Funds? Well, all Target Day Funds in an effort to grow assets over time start out with a high percentage of the fund invested in equities or stocks. So if I’m in, if I have a 2060 fund,

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which means I’m not going to retire until 2060. For most of those target date funds, regardless of the provider, they’re going to have a high equity percentage in stocks invested, often as much as 90 or even 100 % I’ve seen in equities. That’s where it’s going to start. Now, that percentage gradually reduces over time until an individual hits their retirement date. That reduction in equities, that reduction in stocks over time, so then by the time I get to my

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I’ve made it to my 2060 target date, maybe it’s adjusted to 50 % equities or I’ve even seen 30-25 % equities. That’s known as the glide path. I kind of hate that term because that’s another term that’s designed to confuse participants, I think. Think about it as a risk reduction path. Less equities equals less risk. That’s a good way of explaining how the target date funds behave. Now for some funds, the risk reduction path ends at retirement.

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with the fund reaching its lowest equity at that date. And that type of fund is generally known as a to-retirement fund. I’m sure you’ve heard that term before. Other funds continue to reduce their equity or stock percentage until a much older age. For example, some of them go until age 90 or 95. That kind of fund is known as a through-retirement fund. And regardless, by the way, whether the fund is to retirement or through retirement, TDFs have to make certain

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that while providing sufficient opportunity for growth in the years leading up to retirement, they’re not overexposed to equities at the target date at retirement age. Why is overexposure to equities at retirement age bad? Why is that not a good thing? Because that’s when typically an account balance is at its highest point. We did this math thing in a retirement podcast episode, you may recall, in the past. But when you’re obviously at your highest point,

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you can lose the most dollars. And that’s what’s called down capture. A significant dollar loss on a retirement plan portfolio just when the participant might be ceasing contributions and commencing distribution. So it’s a kind of a double whammy. They may have a million dollars in there and if they lose 30%, that’s $300,000. And now they’re not putting money in anymore and they’re taking money out. So that’s really a bad thing and you want to avoid that. And down capture has been kind of exposed during COVID-19 where investors need a retirement age.

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lost hundreds of thousand dollars in a single month because they probably had a target date fund that was too overexposed to equities relative to their risk. And they might be over K with that. Their risk tolerance might be okay for that. That’s what you generally want to avoid, I think. Now some customized TDS attempt to manage the downside risk by saying, you know what, that million dollars you have in your 2020 fund, I’m going to take some of that and convert it.

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to an annuity payment or some sort of monthly payment similar to social security. So I’m going to match it down the right way so that when the market goes down 30 % and the target date fund goes down 25% because it’s not going to go down as much as the market. That’s okay because of your million you’re going to have $100,000 or $200,000 that in annuity that’s giving you a stream of income already.

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As you know, I’m probably not a huge fan of annuities because a lot of times because of their cost. So let’s recap it. Two elements that are key really in evaluating to targeted funds that are different than our types of funds are the risk reduction path or the glide path and the potential for this down capture retirement age. That makes them different than evaluating most every other type of mutual fund out there. And unfortunately, you have to not only evaluate those things in targeted funds, but you have to evaluate all the normal stuff.

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Things like fees, risk return, they exist with TDFs as well. So as a plan sponsor, you really need to work with a real quality advisor who specializes in these types of things. Cause I can tell you not one size does not fit all with regard to evaluating targeting funds and they’re tough to evaluate. Participants, same thing. You got to get all the information you can and rely on your plan sponsors and your record keepers. You know, look before you leap because you don’t want to be surprised. Like some people are in a COVID pandemic about how much stocks they actually had in their 2020 fund.

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Quickly to our trivia question, the answer, 8.8 % in 2008 was the percentage of target date fund assets. In 2018, believe it or not, that nearly tripled to 22.7%. If you were within 5 percentage points of that, give yourself a pat on the back. That was a tough one. I thank Jack Towarnicky, by the way, of the American Retirement Association for providing those stats. That about does it for Karen McCauley. I’m Mike Webb, and this has been…

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Revamping Retirement.

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The content in this podcast is for institutional investors and plan sponsors. The information is intended to be educational and is not tailored to the investment needs of any specific investor. All examples of investor gains and losses are hypothetical and intended to illustrate the importance of early saving and consistent retirement contributions over time. Investment decisions should be based on an individual’s own goals, time horizon, and risk tolerance. Nothing in this content should be considered as legal or tax advice and listeners are encouraged to consult their own lawyer, accountant, or other advisor

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before making any financial decision. Thank you for listening to Revamping Retirement.