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What's Behind Target-Date Funds' Popularity?

Adam Zoll

Adam Zoll: For Morningstar, I'm Adam Zoll.

Target-date funds have become an increasingly important part of the retirement savings landscape. Here to talk about trends in target-date funds is Jeremy Stempien, director of investments for Morningstar Investment Management.

Jeremy, thanks for joining me today.

Jeremy Stempien: Thanks for having me, Adam.

Zoll: Let's first talk about the role of target-date funds in the retirement landscape. These target-date funds have seen massive asset inflows in recent years. Why is that, and where is it headed?

Stempien: I think the biggest reason we have seen the flows just skyrocket over the years is that it's the popular choice for plans to offer as the default of investment option for participants coming in, or some are re-enrolling participants into the plan. And this has been the popular default for plans. I think somewhere around 60% of plans with a default have chosen target-date funds.

As that's occurred, assets have continued to skyrocket into them. Today assets are estimated collectively in the target-date universe as somewhere around $1 trillion overall.

Zoll: We are also seeing plans auto-enroll their employees in these 401(k) plans, and then by default, put them in the target-date plans, correct?

Stempien: That's exactly what happens. They will set it as the default. Any new employees coming in will automatically go into the target-date funds.

When we look at the dispersion of assets and people, what you see is, the bulk of the dollars are [held by] people within 15 years of retirement. Over half of the assets sit there, as those are the people with large balances.

But when you look at the actual number of people, probably the younger generation or the people under the age of 40, the bulk of the people sit there, because they are the ones entering the workforce and being automatically enrolled in the target-date funds.

Zoll: One of the other trends we have been watching is an increase in customized target-date funds. Can you explain what is a customized target-date fund and why would a plan provider go that route?

Stempien: Custom target-date funds, as you mentioned, are a trend in the [defined contribution] world today. So more plan sponsors are choosing to at least explore custom target-date solutions, because I think for all intents and purposes, they are a better solution typically.

In a custom target-date solution, what happens is, a plan can have their own unique demographics of their participant base evaluated, and the glide path or the aggressiveness of those target-date funds can be tailored to the unique characteristics of that plan's participants.

In addition, I think, a big reason a lot of plans really like the idea of custom is that, plans often spend a lot of time and energy choosing their menu of investment options. And when they go custom, they can use those investment options on their 401(k) plan or the DC plan to actually be included as the underlying investment vehicles in a target-date fund, because target-date funds are funds of funds vehicles. They are comprised of multiple asset classes and underlying managers.

The way we think about it is, if as a plan sponsor, you are willing to be a fiduciary of the funds in your lineup, if you're choosing a retail [target-date] series, if you're not willing to be a fiduciary on all of the underlying investment options in that off-the-shelf or retail version, then you should really think twice about if you're OK putting that on [the plan menu], and then on top of that defaulting your participants into those funds.

Zoll: You mentioned the role of demographics in a customized target-date fund. So for example, if you have a workforce that tends to skew older, might you customize the series in a specific way, or if it's younger?

Stempien: There are a number of factors. We are not in the black-and-white world. There is not one factor that would say you should go custom or not. There can be a variety of things.

I think some of the most common things that we see are, in today's world, lots of plans had defined pension plans--defined benefit plans--and we are moving to more of the defined contribution plans [such as 401(k)s]. So we see a lot of plans out there that offer maybe a pension or maybe they have a pension that's frozen. Some participants get it; some participants don't. Those are cases where a custom solution can be much better. Company stock is another one. Some companies say, our participants like to hold a lot of company stock. Well that should be factored into that glide path decision-making process.

And when you go custom, factors like that can help dictate, really, what should that glide path look like, and as your participants change over time, so too will your glide path.

Zoll: What about other trends--you are probably keeping an eye on fees. How are target-date fees tending to trend?

Stempien: Fees are probably the most well-known, the most talked about, and I think for very obvious reasons, fees are an important component.

Because of this spotlight on fees, which I think some could argue is maybe overemphasized to a point where plans are thinking too much about fees and not other things. Fees should be one component of a number of things I'd consider, but a very important component.

And because they consider fees, what we see is this continued trend of plans moving to more collective trust versions of target-date funds, maybe more passive versions of target-date funds, which are all great things. But again, just because it may be the cheapest target-date solution, doesn't necessarily mean it's appropriate or the best. I think that should be an important consideration. And clearly the numbers show that, as we see the trend toward more collectives and passive investment target-date funds.

Zoll: Jeremy, it's certainly interesting and worthwhile watching what's happening with target-date funds, because I know so many people are opting for that all-in-one option for their retirement savings.

Stempien: I couldn't agree more. We think, generally, target-date funds are a great thing. Even a below-average target-date fund is generally by far a better investment option than what most people can do by themselves. So target-date funds, in-and-of themselves, are great. But certainly even within that spectrum, there are a lot of differences that I think people should be thinking about and plan sponsors should be thinking about.

Zoll: Thanks for joining us today.

Stempien: Thanks for having me, Adam.

Zoll: For Morningstar, I'm Adam Zoll. Thanks for watching.

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