Target Date Funds vs. Risk Based Portfolios

The battle over 401k dollars is in full force as designated investment managers continue to jockey for position with the hearts, minds and pocket books of today’s retirement plan participants! What the investment industry gave birth to in the 90’s, known as the “balanced” fund, has since evolved over the past 2 decades into risk based portfolios and Target Date funds.   This has formed a debate within the retirement plan community over which investment vehicle is more appropriate for retirement plan participants, Target Date Funds or Risk Based Portfolios.   Let us start with identifying the design and goals of each investment vehicle before we get into the debate over which is better; if that in fact is the proper question? 

Target Date Funds

The birth of the Target Date fund has be traced back to the early 2000’s, however, the investment of qualified plan assets into these vehicles exploded after the Pension Protection Act, also referred to as the “PPA” in the industry, allowed for the TDF to be used a Qualified Default Investment Vehicle in 401k plans under ERISA.  This created a default option that would allow for the investment into a portfolio of securities structured based on solely time-horizon to be used as a default investment for participants in lieu of the money market; or cash.  

Target Date funds typically are a suite of investment funds structured into asset allocation portfolios based on incremental time horizons.  Commonly structured in 5 year maturity dates, Investment managers will construct portfolios from current date maturity to upwards of 50 year maturities. The idea is centered around the historical investment theory that the amount of risk taken in an investment portfolio should be greater the longer the time horizon available before drawing down against the investment.  This creates a staggered suite of portfolios in 5 year increments; both up to and or through, a designated retirement age, commonly age 65.  Now, let’s look back on that last sentence and highlight the statement, up to and through! 

This has created a distinction and some confusion within the retirement plan community, particularly among participants. The investment industry has designed what we call a “glide path” to determine the path of asset allocation transition between the current date and the so-called, date of retirement.  This “glide path” will dictate how much equity exposure a Target Date Fund will have at a given maturity date in each fund.  Those TDF portfolios that are designed to invest “up to” retirement will create a sharper reduction in the equity exposure as a participant approaches the set maturity date of the portfolio, or the intended theoretical “retirement age” (See Exhibit: a).   This follows the strategy that will reduce volatility in the portfolio to the lowest at the closest point to retirement.   In contrast, those TDF portfolios that are designed to invest “through” retirement, are structured to invest through the maturity date with a longer investment time horizon and therefore a higher level of equity allocation past the stated retirement age in the portfolio.  This is on average somewhere around 6 to 7 years after the stated maturity date in “through” TDF portfolio.  This “To” vs. “Through” debate, is a sub-debate within the context of the TDF vs. Risk Based Portfolio discussion.  Given the scope of this discussion is focused around the merits of TDFs vs. a Risk Based Portfolios, we will leave the debate of “To vs. Through” for another day.  

 Exhibit A: Comparison of “to” versus “through” funds © 2015 Morningstar, Inc. All Rights Reserved.

TDFs have become a very popular vehicle for 401k participants seeking a turnkey investment vehicle that requires little understanding of the investment process in a singular investment fund, that will adapt to the changing risk profile inherent in the lifecycle process. 

Risk Based Portfolios

The term risk-based investing has been around for decades as risk and return are at the cornerstone of most investment strategies available in modern portfolio theory.  RBPs are designed to achieve a given level of return within a range of acceptable risk.  Risk may be measure in various metrics to determine, Standard Deviation, Minimum variance, etc.  True asset allocation portfolios are designed to identify an investors targeted risk/return balance and engineer a constant portfolio mix to achieve this balance on a constant basis.  This requires maintaining that constant balance over time.  So, this is where the deviation from Target Date Funds begins.  While both Risk-Based Portfolios and Target Date Funds are asset allocation portfolios, only Risk Based Portfolios maintain the targeted risk/return ranges over the duration of the funds lifecycle. 

Ideally, most suites of RBPs are designed to achieve returns that are situated along the efficient frontier (See ex. B).  For those a bit rusty on their portfolio theory, the efficient frontier is the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return.  

EX: B (https://bri.managedaccounts.io/article/using-efficient-frontier-alternatives) 

While number of models and asset allocation along each risk category differ from firm to firm, the basic theory of increasing return for each additional unit of risk remains universal.  As an investors risk tolerance increases, they will move along the risk curve from left to right, or conservative to aggressive.  The more risk an investor is willing to take in their portfolio, the greater the allocation to more risky investments in the risk-based portfolio. 

Exhibit C demonstrates 5 risk-based models spread across the risk/return curve.  Each model consists of a different asset allocation mix based on a targeted risk/return range within each of those respective models.  The models are guidelines based on how an investors feels about risk at a given point in time.  While a TDF looks purely at an investor’s age to determine how an investor should be invested at the initial point of investment and creates a glidepath for how that initial risk/return allocation will be rebalanced over time, the Risk Based portfolio remains constant over time.  RBPs are rebalanced periodically to maintain that constant risk/return balance targeted in that particular model.  One could argue that the Risk Based Portfolios are static relative to a portfolio investment, while the Target Date Fund is dynamic and evolves.  

TDF vs RBPs – Which is better?

The competition for retirement plan assets continues to grow into a fierce and competitive battle. In discussing from a head to head standpoint, which vehicle is a better investment platform for participants, the answer truly is; It depends!  It depends of a variety of factors that are unique to each individual plan participant.  As with most investment discussions, customizing advice is a critical part of success.  On one hand, the simplicity and turn key nature of a Target Date Fund has added to its explosion in popularity.   The majority of active plan participants prefer to leave the long-term investment management decisions to professionals.    This is what makes a Target Date fund so attractive to plan participants.  Knowing their age and expected retirement date is the only real determining factors required. Now, while all of us know how old we are, not all us actually will know the intended date of exiting the work force.  It is this uncertainty that throws a bit of a question mark into the planning equation and also provides what we think is pause for some participants, in deciding whether to base their sole retirement investing strategy in a TDF.   As Target Funds evolve closer to maturity, the asset allocation moves left on the risk curve and “de-risks”.  However, the participant is not fully aware sometimes at any given time, the current level of risk in the fund they are invested in.  Whereas, the investors in Risk Based Portfolios know at all times what the current level of risk is in their portfolios.  So, we think that it is this uncertainty of the asset allocation evolution process internal to the TDF that is both advantageous for some and concerning for others.   While we haven’t drawn an age in the sand so to speak, we believe there is a threshold age where the value of potentially being overweight risk in the portfolio is overshadowed by the concern over too much risk and that lack of transparency.    We have tended to see participants over the age of 55 begin to rethink the value of being in a Target Date Fund.  This is because the window of retirement is far closer than those participants looking at a whole working career ahead of them.   

So, while many in the industry will argue that regardless of the glidepath of the TDF family, the Target Date Fund is intended to reduce the exposure to risk as we get closer to retirement, what happens when the retirement date changes? This creates a potential for an unexpected change in the appetite for risk at or close to that retirement age.   In summary, Target Date Funds have tremendous opportunity to right size risk and return for participants with an ample time horizon and at the early stages of investing for retirement.  The simplicity of capturing an appropriate asset allocation in a single investment fund that can be rebalanced over time is an optimal vehicle for the younger to middle aged retirement plan participants.  As participants get closer to retirement, a thorough understanding of how much risk they have in their portfolio at any given time will probably create an opportunity to evaluate risk-based portfolios compared to a Target Date Fund.

 Steven J. Musmanno, MBA, AIFA

Chief Investment Officer/Co Managing Partner

APS Pension & Wealth Management