Defined contribution

The target date funds state of the union

Jan 12, 2018

LifePath®, the industry’s first target date fund, prepares to mark its 25th anniversary in 2018, creating the perfect opportunity to step back and consider the growth and future of target date funds.

Target date funds continue to grow at a rapid pace and have become one of the central pillars of retirement in the U.S. But growth brings increasing demands for efficiency, flexibility, and choice. To help us understand the trends shaping target date funds, and the choices they are creating for plan sponsors, we checked in with Nick Nefouse, co-head of LifePath for BlackRock and head of overall strategy for the funds.

Let’s start with the broad view: if you were asked to deliver a “state of the union” address for target date funds, what would be your key points?  

I’d make three main points. The first is that target date funds continue to grow, and they grow because they are an excellent option for both plan sponsors and participants. They are a highly efficient way to manage asset allocation for a heterogeneous population across an entire lifetime. They do a lot of heavy lifting for participants and plan sponsors.

Number one

Target date funds continue to grow

Number two

Trend toward indexing is strong

Number three

Implementation can be more sophisticated today

What is the second point you’d make?

The second point is that the trend toward indexing remains extremely strong. We recently completed an in depth market research study* with a number of large plan sponsors that gave us insight into the reasons why. There’s no surprise that cost is a major reason. Plan sponsors increasingly see cost as a litigation risk. They are also concerned about inconsistent performance from active managers making it difficult to justify the additional cost.  

Increasing popularity of indexed target date funds

Increasing popularity of indexed target date funds

† Source: Morningstar 2017 Target Date Fund Landscape.

It does go beyond cost: plan sponsors associate indexing with simplicity. They believe participants understand it and that they understand where their return is coming from, whereas participants may distrust the complex explanations behind active returns.

How does the trend toward indexing shift the focus when it comes to selecting a target date fund provider?

We need to put cost in context. Many index target date funds have similar fee structures, often within a basis point or two or three difference. I think proper due diligence requires other criteria should be considered. Certainly the capabilities of the index manager matters. What’s the quality of the team and how sound is their methodology? Do they have sufficient scale to reduce costs and provide exposure, especially for less heavily traded asset classes?

But in my opinion, however, the real premium should be placed on asset allocation and the glidepath as the differentiator between index target date funds. Is it taking risk at the right time? And in retirement, does it reduce volatility while providing growth? Does the asset allocation satisfy the academic case that it will potentially enhance risk-adjusted returns, and the ‘real world’ test that its liquidity and transaction costs work for a DC participant?

The trend toward indexing in target date funds can actually help shift the focus of the conversation to the asset allocation and how it fits together, rather than get sidetracked too deeply into the implementations.

What is the third point you’d make as part of your target date state of the union address?

The third is that implementations, whether index, active or a blend of the two, can be a great deal more sophisticated and complex, with more precisely targeted objectives, than they were just a few years ago. That means plan sponsors have more choices to make in selecting a fund.

"It comes down to value: what is the return you are looking for and how much are you willing to pay for it?"

Does that additional complexity contradict the trend toward indexing you just discussed?

No, I don’t think so. I see the increased choices as different approaches to the same set of problems. To explain what I mean from the BlackRock perspective, let’s take a step back. What are we trying to achieve with our target date fund? We seek to provide a consistent standard of living into retirement based on quantitatively measured risk and broad diversification across asset classes.

High quality index exposures give us a more precise – and hopefully, a more predictable – path to the outcomes plan sponsors and participants want. Even within the index implementation, we are already working with a highly sophisticated multi-asset strategy. However, if the plan sponsor has specific investment objectives or beliefs, it may make sense to explore alternate implementations. It comes down to value: what is the return you are looking for and how much are you willing to pay for it in terms of risk budget and management fees?

How do LifePath Smart Beta and LifePath Dynamic seek to help meet those needs?  

We offer three clearly delineated mutual fund products across the active risk spectrum. LifePath Index is our flagship fund and is one of only two funds to receive the Morningstar Gold Rating.** For plan sponsors seeking more return potential for their participants, LifePath Smart Beta and LifePath Dynamic offer a choice between varying degrees of active risk exposure from smart beta screens and factor tilts to full active management and a dynamic glidepath. Both begin with the same strategic designed glidepath that is the foundation of each LifePath fund.

 

Lifepath Index chart

How does LifePath Smart Beta differ?

In building the glidepath, we begin with the same cap-weighted equity indexes used in our flagship funds, and then screen for factors that have a history of driving return or managing risk. The resulting exposure is similar to the initial index in that it is a diversified representation of a market segment, but it is tilted toward certain exposures to potentially create a different risk or return profile.

Andrew Ang, who was a professor at Columbia Business School and wrote one of the definitive textbooks on factor investing, joined BlackRock in 2015 and partners with the LifePath team to understand how smart beta may enhance the lifecycle investing process. Early in the glidepath, LifePath Smart Beta’s equity exposure is primarily a diversified multi-factor (DMF) index, which tilts toward size, value, quality and momentum factors in order to seek additional growth at market-level risk. The goal of the DMF index is to seek additional return at market risk. Later in the glidepath, as investors approach retirement, the fund will allocate primarily to minimum volatility exposures with the goal of market return with lower volatility.

What’s the process behind LifePath Dynamic?

LifePath Dynamic is designed for plan sponsors who are seeking additional return and may be appropriate for plans whose participant base has a higher risk tolerance or where participants are under-saved. For the equity allocation, LifePath Dynamic will invest in smart beta, cap-weighted index, and systematic equity, while for fixed income they use CoreAlpha Bond and Total Return. The glidepath will be dynamic, within certain constraints, and managed through BlackRock’s Global Tactical Asset Allocation portfolio management team’s top-down macroeconomic process.

For the LifePath Dynamic team, whatever looks attractive from an investment perspective is essentially on the table, subject to the constraints outlined in the prospectus. We don’t expect the funds to trade on a daily or weekly basis—in fact, we may not have an opportunistic position all the time. But the team can make changes when an opportunity emerges. The investment teams ask themselves questions like “Do we think interest rates are going to move in a direction that’s unexpected?” or “Do we think foreign stocks are going to be moving in a direction that’s not expected by the marketplace?” when determining whether there is an attractive opportunity for the fund.

Is there significant interest in customized target date funds?

This year we have seen a substantial increase in conversations about custom implementations. Custom conversations allow us to apply the same robust lifecycle investment model that we use to develop our core glidepath to a specific question or set of questions of interest to a plan sponsor.

"We have seen a substantial increase in conversations about custom implementations."

For example, our strategic glidepath is designed to meet the need of a large portion of the general U.S. population. If a participant population differs in terms of demographics, income patterns or retirement age, we can construct participant income patterns using company data to build a more accurate projection of human capital, which in turn can help us build a more appropriate risk adjusted glidepath for that group.

We can also test the effect of exposures or strategies that the plan sponsor has a conviction around. Interestingly, we’ve even begun to have conversations with plan sponsors who want their social or environmental values reflected through sustainable investing. Another trend is toward open architecture glidepath so that the plan sponsor can include managers from the core menu or the defined benefit plan.

How would you sum up the current state of LifePath?

The LifePath suite continues to grow and evolve, both in terms of assets under management - $200 billon as of 11/2017 - and implementations. For larger plan sponsors, our flagship continues to be index implementation, but we’ve seen increasing interest in custom and open architecture options as well.

No matter which LifePath implementation a plan sponsor chooses, the foundation is our deeply researched, time-tested strategic glidepath. But now we have choices that we believe better align the funds with the needs of plan sponsors, particularly those of mid-size and smaller plans, which often express interest in target date funds that are not purely index-based.

Nick Nefouse
Head of Defined Contribution Investment and Product Strategy
Nick Nefouse, CFA, Managing Director, is a member of the US & Canada Defined Contribution Group. He heads the DC Investment & Product Strategy team, ...