Target Date Funds continue to rise in prominence on the retirement landscape, but what are the key elements of these solutions to keep in mind? Mercer Principal Peter Grant hosts a panel of experts on the major considerations around TDF solutions, the macro landscape and the active versus passive debate.
Peter Grant: I’m Peter Grant from Mercer Investments. And I’m pleased to host today’s discussion, Target Date Funds Masterclass. Welcome, gentlemen. Thank you for coming. This is a very exciting time; three weeks ago we passed through the 10 year anniversary for Target Date Funds becoming the QDIA – the Qualified Default Investment Alternative for Defined Contribution plans. Before today’s discussion I was looking at some recent statistics on asset growth in the industry. And in just the last four years assets have gone from 500 billion to over 1.5 trillion in just a small number of providers in the industry. So it’s a great time to be having a discussion about Target Date Funds. And I’m very pleased that you could make in here today to speak with us. We’re going to cover three topics. We’re going to start with the big picture to get a sense of the landscape, it has been very dynamic. And then go under the hood to understand what your organizations are doing to construct your glide paths and make them dynamic and adapting to today’s environment. And then we’ll close with some thoughts about the future, where do you think the Target Date Fund designs are going. So with that as our general framework for the discussion, let’s get started with the big picture. And I’ll start with you, David, if you could share your thoughts on how the Target Date landscape has changed in the last few years. David: Well, thanks, Peter. And as you mentioned Target Date Funds have grown substantially in assets over the last several years. And that is really the biggest change. And as a result of that asset growth, people are paying more attention; providers such as ourselves are devoting more and more bandwidth and resources to these products. And at the same time, plan sponsors who use them in their Defined Contribution plans are also thinking about them more and making sure that they meet the objective of all of their participants. Peter Grant: And, gentlemen, what would you like to add about the landscape? Chris: I’d just add that while assets have grown significantly as you said, Peter, we’ve seen some other changes, even in the last five years I think plan sponsors are starting to listen to the Department of Labor in terms of determining whether a non-proprietary or a custom Target Date Fund would be a better fit. Just in the past five years we have seen the number of strategies where people were using the Target Date Fund from their record keeper fall almost in half, from 57% to 30%. We’ve seen the number of custom strategies double from about 11% to 21%. But while we’ve seen this great asset growth we haven’t seen the level of innovation that I would like to see. We still see most Target Date Funds force you to make a binary decision, active or passive. They’re single manager, they’re not multi manager. And they’re not particularly well diversified. And I think all that needs to change. Peter Grant: Well, it will be exciting to hear later today about some of the innovations, so how about you, Sean? Sean: Yeah. I’ll just add a little bit to Chris’s point there. I think, you know, increasingly we’ve seen the custom conversation coming up. And with that we get a little more information from individual plan sponsors and the populations around what the actual data looks like. So we can take in data and say, “Hey, your participant base is invested in this manner. They earn income across their lifetimes and in another manner. Let’s incorporate that into a custom strategy.” And so you get a little more pointed in delivering on the objective you want for that participant base. So I think that’s a good evolution. I do agree that to the extent we can get more … I don’t know if aggressive is the right term, but unique asset classes incorporated in a Target Date Fund. Then you can get even more specific in terms of delivering on those objectives. Brad: I guess what I’d add is just what a success story in 10 years, how many average workers in 401(k) plans have been helped by the discipline of not being tactical . . . sensible asset allocation. And then, you know, and payroll deduction and employer match. And it’s just been a phenomenal thing for investor outcomes. So I think that’s one. The second, what I think is striking is how fast the industry is growing. So you’ve got 20% of the assets are 401(k). But it seems that maybe 40/50% of incremental decisions are going into Target Date. And if we started a new company tomorrow with a whole bunch of young people it might be 80% going into Target Date. So the scale of the industry is significant, and it’s had a real positive benefit on a lot of people. The other trend is I feel like we’re in chapter two. I think chapter one of Target Date was the largest record keepers recommended to their plan sponsors that they take their Target Date fund. We’re firmly in the sort of those are two decisions. You have your record keeper decision and you have your Target Date investment manager decision. It could be the same, but often it’s not. And so I think that’s been very healthy for the industry. Peter Grant: Yeah. It’s amazing that if you look at the last 10 years, you all mentioned some of the things that are starting to really pick up today. One of the things that we have seen that I’d love to hear your thoughts on is the effort and focus on demographics. So when they became the QDIA a lot of companies jumped into this space. But we didn’t have that behavioral experience. We didn’t know how to think, well, how are participants going to use the Target Date Funds? So perhaps if you’d like to start with that, Chris, share your thoughts on how do you see participant behaviors and research in that space affecting design? Chris: Well, what we’ve seen from participants is they’ve clearly articulated that they want it done for them. They’re not investment experts and they’re willing and most likely able to delegate that decision now that we have Target Date Funds. We’ve also seen behaviorally that asset location shouldn’t drive the asset allocation. And if you look at what participants are doing when they allocate their own assets. It’s about 60/40 stock bond within a 401(k). For participants that have rolled out, it’s almost the same; it’s 61% in stocks and 39% in bonds in an IRA. So the asset location shouldn’t be the singular factor that drives the asset allocation. The final thing we’ve seen from a participant behavior point of view is participants in retirement tend to spend a little more rapidly than they should, given the asset corpus that they have. And so we have to make sure we incorporate multiple levels of diversification, risk control into their asset allocation because they’re not always behaving ‘optimally’. Peter Grant: What would you add to that, Brad? Brad: Well, I think they’re good points, and the other things I would add are that just demographically people are living longer, that’s obvious. It’s stunning. I think those over 90 — 40 years ago there were 700,000 people in the country. Now there are two million; projections are there’ll be four million in 2060. So people are having 25-, 30-, 35-, 40-year retirements. And so you need really sensibly designed glide paths that both build wealth and preserve wealth, even in retirement. You need a mix of building and preserving wealth. You can’t go straight to preservation. And so I think one of the things that we’re going to see more and more is a focus on that retirement period of the glide path. What type of equities do you have in your glide path at age 70, 75, 80? And what type of bonds? And does that make sense for a retiree? Peter Grant: So, David, you have a lot of public employees that are benefitting from your entity’s work, what would you share in terms of what you’re seeing in that space? David: Well, behaviorally I think our experience matches up a lot with what Chris was saying, that 60/40. Unfortunately we’re seeing that with a lot of younger people doing 60/40. They’re not taking on really the investment risk that they need to in order to get a robust return when left to their own devices. And the other thing that I think we see when people are not in Target Date Funds is a tendency to market time that they believe that they’re going to be able to call the top of the market, there’s going to be willing buyers at that moment. And then they’re going to be able to make the second good decision and get back in at the bottom. The odds are so much against that. And between not having enough risk and the problem of market timing and being unsuccessful at that, Target Date Funds do a reasonably good job of mitigating a lot of that kind of behavior. Peter Grant: Yeah, that’s very true. Sean, would you add anything to that? Sean: Just one more comment on the behavioral side. You mentioned we hit the 10 year mark of when Target Date Funds became a QDIA. And with that we really, you know, everyone at this table or in this room got a good understanding of how participants actually do behave. And from a behavioral economics perspective we know that participants approaching retirement are exponentially more loss averse than their counterparts that are in the earlier stages. So I think, you know, making sure that we take that into account when designing Target Date Funds so we keep people invested in the strategies. And I know we’re going to talk about decum here in a little bit. But the ability to withdraw assets is, you know, it’s paramount that you stay invested in a professionally managed strategy to even have an opportunity to do that in an effective manner. Peter Grant: That’s very true. So one of the other big picture things in addition to participant behavior that we have seen and we’re trying to help our relationships with is pressure on fiduciaries due to the lawsuits in the industry. I’m just curious to hear any thoughts you would share about pressure you’re seeing on fiduciaries due to these lawsuits that are coming after both your companies in the investment management industry as well as plan sponsors directly. Does that have any effects on the design of your glide paths or how you’re working with the various entities? Anybody, if you’d like to. Brad: It’s quite a burden if you put yourself in a plan sponsor’s shoes, what they are tasked with. And I think it’s leading plan sponsors, advisors, consultants to focus on sensible elements of that choice. Is the glide path provider an organization that you trust and has a proven track record and has done what they do well for decades? So forget about the glide path for a minute, just think about that organization. Have they shown that this is core to what they do? It’s not a division of a large conglomerate; it’s really what they do. Have they proven they can go through multiple generations of senior management and keep the organization going? Because you know, a glide path can be a 40-, 50-year relationship. So I think that’s key. I think the quality of the underlying funds — I think more plan sponsors are now focusing as much on that as the top-down glide path asset allocation. Well what are the funds that the glide path has built on? And what are the quality of those funds? And what are the fees of those funds? And what’s the value that investors have received net of those fees? So I think actually there’s more good focus from fiduciaries, but it is a tough job. It’s complicated, and it’s often not the full-time job of these folks. So we try and help them however we can in the industry. Peter Grant: Yeah. No, we find, fortunately some suits are going or a lot of suits are benefitting them, so that’s good news. David: I think a big part of it is transparency. If you’ve done a good job of disclosing what your process and philosophy is, how you run the investments, what your fees are and really be open and transparent about that, it goes a long way to reassuring plan sponsors. The larger ones have really noticed this environment, the smaller ones, not necessarily. But that really shouldn’t matter. We really as an industry have to just make sure that there’s a lot of transparency. And, you know, I think we have a better chance of, you know, making sure that all of these, you know, entities are going to be satisfied. Chris: We just surveyed plan sponsors and specifically, fiduciaries within plan sponsors. And some of the results were pretty troubling. Only 49% of those that were fiduciaries actually realized they were a fiduciary. And that was a little disheartening to see. The other thing for fiduciaries, it’s sometimes easy I think to get paralyzed into not making any decision, that in and of itself is a very active decision, whether it be in the plan design, whether it be in the asset allocation or the choice of Target Date Fund. And we’ve talked about the 10 year anniversary of Target Date Funds and PPA. And that afforded plan sponsors some opportunity to, if they identify a problem to fix it. If you don’t have enough people in the plan, auto-enroll. And pretty much everyone’s done that. If people aren’t saving enough, auto-escalate. And many plan sponsors haven’t done that. If you’re auto-escalating or auto-enrolling, rather, someone in at 3%, you’re doing them a disservice because they’re likely to stay there. Or maybe they save 5% because they want to maximize the company match. But they won’t save 10%, but you can take them there basically without risk because of the PPA. And to the point you made earlier about the poor allocations of participants, a 60/40 for a young saver, you can have a re-enrollment. Ask everyone to reaffirm their asset allocation. And if they don’t default them into any one of our Target Date Funds, would be better than what most participants can do on their own. So there’s a lot of opportunity for fiduciaries to act. And some of them simply just aren’t acting enough. Peter Grant: Yeah. It is true and we face those resistances. And we’re finding that more and more folks are picking up because they’re recognizing the research that your firms are providing on how do you get ready for retirement. You have to be saving certain amounts. You need to be helping folks, encourage higher savings levels. So I’d like to switch gears and start kind of getting under the hood and understanding the plan design and the principles behind the Target Date Funds that your various entities are working on. And so why don’t we start with you, Sean, and you can share the drivers behind your Target Date Fund and primary principles. Sean: Sure. So I talked a little bit earlier about participant behaviors and acknowledging what they’re looking for in their Target Date Fund. And so our approach is one that really wants to take hold of that and deliver what we believe participants are seeking. So in a recent survey that we conducted we found that three out of every four participants wanted their retirement savings to be able to allow them to sustain their current standard of living. So not have to change the standard way that they live from the days that they’re accumulating assets to the days that they’re drawing down. And so what we’ve done is developed a glide path that gets you the optimum amount of risk, in our opinion, to deliver on that objective, which is a stable spending behavior throughout one’s lifetime. And so there’s data that goes behind that of course to support the glide path that we’ve ended up utilizing. I think we can all probably agree that it’s a risk management exercise at the end of the day. So you have to decide where and when you want to take risk. We take the approach that, early on in one’s life, you know, participants that haven’t been active in the markets for a long period of time, they have lower absolute earnings power. They really need to be going for compounding and going for growth in those early years. And on the other side of that you have participants that have accumulated a lot of assets. They’re getting ready to start withdrawing. And you need to start protecting those assets and preparing for those sensitive years in retirement when you want to be able to spend consistently. And so really at the crux of what we’ve done is taken a maximum allocation to risk early on. We think that’s appropriate for a number of reasons. I mentioned lower earnings power, greater ability to earn in the future. And then as you approach retirement, those high balances, those less future earnings years in our opinion means that you need to take risk off the table. And again, that’s built on the data we’ve taken in on how the average American earns income across their lifetime. And that’s a direct input into our Target Date Fund model, and again all at the end of the day trying to get that stable standard of living for participants as they move through their retirement years. Peter Grant: Brad, how about the American Funds? Brad: At American Funds, when we built the architecture of the glide path, we started with a number of key principles. First of all, we did all the similar work that all providers do on a sensible asset allocation glide path for different ages. I think most glide paths look fairly similar from a top perspective, but underneath we took a different approach. First of all we used our flagship funds — our best, most-proven, time-tested funds. And secondly, we have a dynamic glide path within our glide path where not just the amount of equity changes as you age, but the type of equity changes. So when you’re young we have growth-oriented funds, appreciation funds and stocks that those kinds of funds would normally hold. In your 40s and 50s you have a mix — more blue chips, some growth stocks. And then as you approach retirement and in retirement we use our proprietary actively managed higher dividend income funds, much lower volatility — more of the total return is coming from dividend yield and the growth of the dividend. And that really suits the investor along the way. Most other glide paths, they vary the amount of equity. But if you actually drill down and look at the underlying holdings for people in their 20s and their 40s and their 70s, they’re remarkably similar. And these days the index is very growth-oriented. As you probably know, the top five holdings in the index are Apple, Google, Microsoft, Amazon and Facebook. And in many glide paths, other than ours, if you look at the top equity holdings of the 70-year-old, it’s Amazon, Google, Microsoft, Amazon, Facebook. And we think that doesn’t make sense. And so we vary the type of equity and the type of bonds. Many glide paths, they start with a small amount of fixed income, it gets larger and larger, but the character of the fixed income is fairly generic. The character of our fixed income changes as you get to 60, 70, 80 — more preservation, more stability-oriented, shorter duration, higher credit quality. So we took, I think, a more dynamic multi-level approach to the glide path. Peter Grant: Great. How about ICMA-RC? David: What I’ve found interesting here, where Brad has discussed it, because we have moved a little bit away from that approach of the glide path within the glide path. The only one that really remains is inside fixed income, that as you move along the glide path, duration gets reduced and you’re more likely to have some short term fixed income. But what our philosophy has been is that over the course of time, growth versus value, for example, tends to be correlated in time. And there will be long periods of time where growth is going to do well and then oscillate to long periods of time where value is going to do well. So we have decided that having a consistent approach and to manage it that way is superior over time, so that if you start in the glide path and you’re in there for 30 years, you have a sufficient amount of time to have enjoyed both growth or value, that you don’t really want to necessarily be in growth when value is in favor or the reverse. So we’ve taken that approach. In terms of how we build this, the whole thing is anchored on long term capital market assumptions. We start there and we move forward with correlations, peak earnings and replacement ratios. And then we finish in the decumulation stage, making sure that the money is going to last, given the assumptions that match up to an average investor. And that’s the most important thing that we find, that the biggest determinant of success is going to be your contribution rate. There’s only so much that we can do as providers if you don’t match up with the assumptions, the contribution, right. If you’re going to put away 1 or 2% a year of your income, all bets are off and you’re not going to have, you know, the success that we have been predicting otherwise. Peter Grant: I remember 10 years ago I was reading a report and actually Alliance Bernstein had produced it and they had researched the effect of various glide paths on different age cohorts. And it’s clear that certain age; if you’re going through a very difficult market environment and you’re retiring it’s a challenge. So I’m curious to hear how things have evolved over the years at Alliance Bernstein in terms of the principles and the approach to your glide path: Chris: Sure. I would agree with, Sean, it’s a risk management exercise. But it’s really, what’s the critical risk to manage for each age cohort? And for a young saver’s growth risk, everyone has a fair amount of equity in their portfolio, but we need to diversify beyond equities. Because while equities might normally return 9% a year, we don’t have a normal environment, today it’s more like 6%. Bonds are not yielding 5, they’re yielding 2. And they’re unlikely to materially offset equity risk because yields are so low. They don’t have much room to fall. So we have to diversify beyond traditional bonds and to global hedged bonds or unconstrained bonds, cash plus, that can provide the main purpose of bonds in the glide path, which is to offset equity risk. But do so in a way that doesn’t expose participants to duration risk. And a lot of people think about equities falling as the key risk to manage. But there is the risk of inflation shocks and there is the risk of rising interest rates. And while we have a framework to implement that on a very strategic basis, we also implement what we call a dynamic or a tactical overlay. It’s not clearly there to juice returns, forecast future returns and try and model those, that’s really hard to do. The main driver for us making a dynamic or a tactical underweight or overweight is our view of risk. And there’s a persistence in risk that is not there in return, which allows us to forecast more accurately. And we’ve been overweight, modestly, but 3 or 4% this year, which has served us well from an equity perspective. When all the concerns about China came to bear in that growth, in late 2016 we were underweight 6 or 7%. So there’s a lot going on under the hood. But we have to manage that top level glide path as well to really deliver both the returns that participants need, but control the risk along the way. Peter Grant: Well, you all interestingly have touched on the complexity of these Target Date Funds. And so the next section we’re going to try to do a deeper dive on three areas. And so let’s … well, everybody can share their thoughts; we’ll kind of make a move quickly because there’s a lot to go into. And the three areas are active and passive within the construct. The other area is going to be the dynamic nature; folks are a little bit concerned with today’s market valuation and is there, you just mentioned that tactical component. And then we’ll get into the decumulation phase. So we’ll touch on each one of those and hoping to hear your perspective for each one, so, why don’t we start with you again, Sean and then go with the active versus passive. Sean: Sure. I guess I’ll start with saying that I don’t believe that any Target Date Fund is truly fully passive. You’ve got managers, all of us are making decisions around where and when to take risk, being the glide path, the split between equity and bonds. You have a decision around what asset classes you want to incorporate. And then of course the implicit belief by going with fully active management, if it’s all proprietary, is that that manager is best in class across all categories. That’s certainly possible. What I will say is our flagship product is one that is passively managed on the underlying asset class level. You know, we’ve been a beneficiary of kind of the trend towards index, broadly in DC. And that’s great. We’re agnostic when it comes to underlying implementations. We have products that span the spectrum. We have a product actually very similar to the one that Chris just described at Alliance Bernstein. But broadly, I think that we find even our passive strategy is one that’s been developed to last, you know, a 40 or 70 year investment horizon. So across the entire accumulation years for every participant and then all the way through their retirement years, which hopefully is getting longer and longer, and the longevity risk that was referenced earlier. And we believe that a broad low cost efficient exposure is going to get participants to a good outcome at the end of the day, assuming that you have the savings rates necessary to get there. And none of these investment products can help a participant invest their way out of a savings problem, in my opinion. And so it’s all about a partnership with the firm that you want to move forward with. Brad sort of intimated this; the investment product is of course all these professionally managed solutions are very good. And often they may deliver a better outcome than a participant doing it themselves. But you need to couple that with the resources and the education at the participant level to get them invested and saving at the appropriate rates. So we’re again, agnostic on the implementation side. I don’t think there’s anything as a truly passive Target Date Fund, we’ve benefitted in our passive Target Date Funds just due to the trend towards lower fees, and that broad persistent exposure I think can still benefit participants over long periods of time. Peter Grant: So, Brad, your firm obviously has a lot of active management in it, so let’s hear your thoughts on. Brad: Right — all active, and I agree with Sean that there is no passive choice in Target Date. Not only is a passive-based Target Date glide path, someone has to make an active decision on stock/bond and U.S./non–U.S. And so right there you’re active. But secondly, you’re making a very conscious choice to have your underlying stocks and bonds be on autopilot — mimicking the market, not making any judgment about whether things are undervalued or overvalued or the prospects of the future. And so we have as a firm an 85-year history of our funds over long periods of time beating the index net of fees based on research and judgment, and a process and a time horizon which is different than the market. So I think passive is a very conscious choice. And what you’re getting with passive is you’re guaranteed that you’re going to get average. You’re guaranteed that you’re never going to beat the averages in a down market. And what we’ve seen from the passive-based glide paths is that they tend to be more volatile. They do well on the up markets and they do much more poorly in the down markets. And interestingly, in the last 10 years we’ve had really four up-channels and four significant corrections post-world financial crisis that were double-digit. And what we have seen from American Funds Target Date glide path is that in the up-channels we’ve been about median. We’ve held our own, even though we’ve had some cash and some dividend-oriented stocks. But in all the down cycles we have been top quartile. And that’s from that judgment, the ability to say that the market maybe is overvalued, or certain stocks are overvalued. So I think that trade-off, and now some of the active based glide paths are layering in passive. We’re not. We don’t think we need to. We don’t have fee or capacity issues, but it’s getting more complex than it used to be. Peter Grant: Chris, now, you mentioned tactical aspects earlier. So I’m interested to hear if there is an aspect to active and passive that would relate to some of the things you were referencing in your last comments. Chris: There is. And we believe in a mix of two. In our package products we’re not a 100% one way or the other. We should use that active risk budget where it can really help add value. Do we think the manager or the strategy will deliver alpha above the benchmark? Is it particularly there for risk control? We’re mixing that with passive in certain asset classes where you’re less likely to be able to deliver value. But on top of that you then have to look at, well, what is the complementary nature of those managers you’re incorporating together. Are the style exposures diverse? Are the factor exposures diverse? Are the alphas when they outperform, likely to be correlated or uncorrelated? The other thing we’ve done from an implementation point of view is, is we haven’t constrained ourselves to one universe and we’ve moved to a multi manager structure, which is pretty unique in terms of packaged Target Date Fund implementation. But it’s not unique at all when you think about how Defined Benefit plans are managed or endowments or in foundations or even core menus. So these are some best practice tenants we think that can be incorporated and will be incorporated more and more into Target Date Funds over time. Again to achieve that dual purpose of delivering the growth people need but doing it in a way that consistently controls risk on the downside. Peter Grant: Now, David you had mentioned the challenge of valuing growth moving in and out of cycle and phase. Does that apply to active and passive as well? David: It does to some extent. But I’m really glad that Brad and Sean mentioned the idea, which is I think well-known to us, but not well-known to plan sponsors and the general public at all of these Target Date Funds. The primary determinant of how well they’re going to do is the glide path construction. What is the asset mix? And how much risk did you take? And that of course as we know is an active decision; people think there’s active glide paths and passive glide paths. No, not really, all these glide paths are really an active decision. Somebody’s sitting around the table and making an active decision. So that said, what goes into these products? And we have a mix of passive and active, usually about a quarter are passive. But we also have in some cases what I would call near passive. We have things like equal weight indexes in some of the underlying strategies that we think have a good probability of over time outperforming the capitalization weighted indexes. So when you put it all together there isn’t one right way of doing this. And we think a blend of both active and passive for the underlying investments is a smart idea. One example is that we had passive for emerging market equity, we think that that’s an area in which there’s a lot of opportunity to be active. And that the odds of outperforming on an active basis may be higher than other asset classes that may be a little bit more efficient. So that’s a place where we’ve gone the other way and we’ve gone from passive to active. And we’re always going to make those kind of decisions based on really how, you know, effective is the asset class for, you know, for passive or active management. Brad: You know, another thing, Peter, that’s interesting on this is the question of where is the decision-making on tactical happening? And I think there are very different approaches in the glide paths. Most glide paths use relatively style-pure component funds. And then there is a committee or someone who is tactically making those decisions. The way we decided to architect American Funds’ glide path is to have — instead of a single line of asset allocation that was precise — have a channel, essentially historical flex of the underlying funds, whether they be geographic flex from some of our globally flexible funds where the portfolio managers on the ground are deciding between Samsung and Apple or Daimler or Ford, and some multi-asset or balanced funds where the portfolio managers are deciding on the ground, should I buy Verizon stock or Verizon bond? And so that has allowed us to have, we think, a more opportunistic on the ground tactical asset allocation within a sensible channel as opposed to style pure component funds where someone is meeting on Monday morning or every month and trying to do that from the top down. Peter Grant: And, Sean, how do you all bring that perspective in this? Do you have a tactical element within the framework? And is it market valuation based? I think a lot of folks are worried about the market being a little expensive and so does it work through valuations? Or is it through more of a bottom up type framework that Brad just mentioned? Sean: So the strategy that we maintain that has the global tactical asset allocation is a top down macro approach. So based on where our portfolio managers see value or over value, you’ll see some shifts underneath the glide path, and movements in the glide path to take advantage of certain market conditions. And then underneath that we have the bottom up active approach in the underlying asset classes. So I call it our active strategy. And so we have clients spanning the spectrum. Of course I mentioned our passive strategy being our flagship. But we have everything from that fully passive to that fully active. And then I think one thing that we haven’t really brought up yet is there is a category that sits a little bit between active and passive, which is smart beta. This conversation has come up increasingly from our perspective in the institutional space. And what we’ve done is created a Target Date strategy that is focused on capturing actual factor based exposures. So you can broadly think of factors as persistent drivers of return over long periods of time, with the idea being that you’re going to get some better risk adjusted returns relative to a market cap based strategy. And if you can capture those efficiently in a portfolio and ultimately wrap it into a Target Date Fund, which is what we’ve done, then participants are going to achieve better outcomes as a result. So you know, I think active and passive, there’s a place for both certainly. I agree that blending the two categories together is usually the best approach from a portfolio construction perspective. But then also thinking about how factors can impact your portfolio in a positive way. We talked about the correlation of active managers a moment ago. Some of these factor based strategies that are being utilized actually maintain low correlations to the way that some of the active managers are driving their alpha. So you can get some nice outcomes by blending also smart beta and active strategies. Peter Grant: So now we’re going to switch gears and talk about decumulation. Obviously it’s getting more and more attention because of longevity risk, the demographics that are showing now that folks that are entering the workforce in a few years, most of them are going to actually live over a 100. So how do we deal with this issue? And so how about we just run through each one of your firm’s perspective on the decumulation part of the glide path and some of the principles behind it. Brad: Great. Well, we’ve touched on this before, but let’s not forget the most important thing in the decumulation period is to have as much money as possible at that time. So you want to have, again, the largest percentage contribution you can bear, the highest employer match, auto-enroll, all of those things. You also want to be invested in a program, and Target Date glide paths are a great option that is geared toward building wealth and preserving wealth and has sensible asset allocations. So doing all those things well should get you in a better place for that decumulation period. I think this is one of the most fruitful areas for the next 20 years of the 401(k) market and Target Date is how do we handle in retirement? And I think there’ll end up being a menu of options all the way from guaranteed insurance-type of contracts to withdrawal-oriented portfolios that are not guaranteed, but are built to be sensible for a withdrawal program when you’re in retirement. And what’s interesting about American Funds Target Date glide path in retirement is first of all we do continue to glide for 30 years. So it does not go static. But also what I mentioned before about the type of equities and the type of bonds that we have in retirement very different than most of our peers. Our equities are overwhelmingly actively managed high-income/equity income-oriented strategies where most of your withdrawal rate would come from the dividend yield, much lower volatility. So those are ideal for a withdrawal program. And then as you look at our bond portfolio in retirement, it gets much more stability/preservation-oriented than some glide paths. So we think that even if one were to just do a withdrawal program on our glide path, it would be sensible. But people are going to need more options. And I think that if we’re back here 10 years from now you’re going to see plan menus having maybe a whole retirement tier. You’ll have your growth tier. You’ll have Target Date, and then you’ll have a tier of retirement options. And we need that; it’s a failure right now of the system. David: Definitely the move towards personalization and what people really need versus just a standard one size fits all. Peter Grant: Yeah. So how about Chris, you share your thoughts. Chris: Sure. In terms of decumulation it gets back to something I was mentioning earlier about really controlling for the risks that are most prevalent at that point in time. Someone’s longevity risk is greatest at the point that they’re retiring. They’re likely to live another 20, if not, 30 years. And we have to deliver enough return to them to meet their spending needs. Again, in a constrained expected return environment, that becomes increasingly difficult and begs additional diversification. As, Brad was saying, the notion of a glide path within a glide path, we’re doing that within equities. We’re doing that within our inflation sensitive assets as well, mixing in real estate and commodity futures, along with TIPS. Because think about that person who’s just retired, they don’t have enough inflation sensitivity in their portfolio, if there is a shock their value falls. While at the same point in time their real spending needs are rising, that’s a really difficult place and one I don’t want to put them in. And then finally, within fixed income, I mentioned briefly, global bonds earlier. We’ve done a lot of work and a hedged global bond exposure, because I don’t want to take on that additional currency risk, does a couple of things. One, it helps offset equity risk better in a rising rate environment here in the US. And I know we’ve been talking about that collectively for quite some period of time. But that’s going to happen eventually. And that’s a key risk that we have to manage for the participants, as well as deliver a return that’s above and beyond what we’re getting here just with nominal core bonds, so all of that is really important. I also agree that we need more innovation. However, when you think about participant behavior, we could have 5 or 10 or 20 options for participants, whichever one is the default is going to get all the dollars. So I think it behooves all of us to make incremental enhancements to the default strategy, whether that’s a Target Date Fund or something else, because that’s where all the dollars are going. Peter Grant: David. David: Well, for me it’s, as I get older and I see friends and family go through this exact lifecycle, where they retire and they spend a little more initially when they retire. That’s a point when people may relocate to a new retirement home or they may say there’s all this pent up demand to do travelling and all that. They spend a bit more early on at retirement which exacerbates the idea of people spending more and being most vulnerable at that retirement. Typically what I have seen is from their spending will drop a little bit, only to come back later on as long term care needs start to be a part of peoples’ spending in their lives. So we like most other firms look at this on a linear basis. We use a 30 year period withdrawing 4% and longevity becomes a big factor. You look at a group of people now who are 62 years old and it’s particularly women, approximately 25% of women are still around at aged 92, 30 years later. So longevity is a big factor. The money has to last. And I think we tend to be in the accumulation phase a little bit more aggressive than our peers. But I think in the decumulation phase we tend to be a little bit more conservative and, you know, really try to limit that volatility. Peter Grant: Sean, what is BlackRock doing to decumulate? Sean: Yeah. It’s such a good topic and I’ll just build a little bit on what Chris was saying that if you look at what the DOL is doing, expanding the role of the fiduciary. I think the general assumption is that’s going to mean that assets stay in plan, more so maybe than we’re seeing today or in the recent past. And so agreed, to the extent you can get these income solutions into the default options where the majority of assets are going to be sitting, the better off participants are going to be. Now, our research shows, and we’re a little bit different here than my friend, Brad, that we maintain that static allocation to risk throughout the retirement years in our glide path. With the understanding that that is the best way to secure a stable manner of spending, as I mentioned, being our objective, in the absence of going with a full blown annuity through the retirement years. Now, we had a strategy that sadly was not taken up by the marketplace about five years ago that actually built an annuity into a Target Date Fund. We thought it was a beautiful structure; there were issues in implementation from a plan sponsor perspective. But I do think that, I agree, if we come back here in 10 years we’re going to see these strategies with a more convenient way of a built in annuity structure in a Target Date. And what that might look like is a portion of the fixed income category is allocated into something that tracks the cost of an annuity due at retirement. And then of course it will be incumbent on the plan sponsor or a consultant or somebody to talk to a participant about, “Hey, take this to the annuity marketplace and go buy that income.” Or build in a laddered bond structure such that we can try to meet the liabilities of a participant as they’re moving through the retirement years. Doing that in a Target Date Fund where the majority of assets are sitting, I think there is a quote about 90% of future flows going into Target Date Funds. Those are big numbers. And so if we can get income and good income solutions built into a Target Date, that’s really what our goal is. And I think that would help a lot of participants as they move into their retirement years. Brad: One thing, Peter and Chris mentioned a variety of alternatives a couple of times. And so I’d just like to take the other side of that because we’ve looked at this extensively, and I think for a QDIA core 401(k) program that Target Date is for average workers who need to engage in the glide path. We really need to think about whether loading them up with all manner of alternatives in sort of the name of hopeful diversification from equity is the right thing to do. Because you’ve got not only a question of whether they’ll behave as they maybe did in past decades, you’ve got fee levels in a number of those securities that are high. You’ve got capacity issues. If we’re going from one-and-a-half trillion to three trillion to four trillion, and the complexity I think for a plan sponsor committee for the average 401(k) investor, trying to understand what futures and private equity and hedge funds they have. And for many, many decades, for hundreds and hundreds of years people have invested sensibly in public equities with a good asset allocation, with attention to risk, using the right kind of equities and bonds at different times and didn’t need all of those things. And we think cash is a great diversification to equity. It’s liquid. It’s very low cost. We know what it does. TIPS are highly liquid, low cost; we know what they do. And those . . . and short-term government bonds and you can do a lot. And then some things like commodities, you can get at, maybe not fully, but in a much more liquid way by owning energy stocks, more mining stocks and so forth. And REITs can serve a purpose for private real estate, which is illiquid. So I think we’ve got to think about this a little differently than the Yale Endowment or something like that. This is a big core middle of the fairway kind of consumer product. Chris: And maybe I’ll just add one point. I agree with you, I don’t think the Yale Endowment is what the typical participant needs or wants or the plan sponsor from a Target Date Fund. But we do have to think about the current environment. We’ve talked a lot about equities, but think of someone who has 40 or 60 or 70% in bonds in their portfolio. It’s, again, not really going to offset their equity risk and they’re going to get little, if any, real return above inflation over the next 5 or 10 years. This tailwind of a 30 year bull market and falling rates is behind us. So we have to look beyond the maybe plain vanilla asset classes that have been used. And I’d say successfully in many Target Date Funds post the global financial crisis, because what all of the Quantitative Easing did was take some returns that we should have experienced in 2018 or 19 and 20 and allow us to pre experience those which means those future returns are going to be less. So we have to find a way to move beyond and incorporate additional ways of diversification for both the return and the risk control. Brad: And that’s a bigger deal for glide paths that have index-like or very growth-oriented equities throughout, which is honestly most of the assets in the industry are. So if you have those kinds of equities for a 50-, 60-, 70-year-old, then you probably do need to work harder on diversifying and putting the brakes on those. But if you significantly change the character of the equities from the largest growth companies to blue chip, high dividend, slower moving then you have less of a need to stretch on alternatives to offset the equity risk. That’s our opinion. Sean: I would suspect and this is my own opinion that it’s going to take some movement out of Washington for plan sponsors to get comfortable with having alternatives. There’s just … we’re actually, we’re talking about decumulation here. Liquidity is very problematic, even if you have a long term horizon and pricing is a challenge. So the real alternatives out there are probably going to be hard to get in unless Washington provides some protection. So that’s, you know, what we’d suspect is, we’ve talked about this for about 10 years now and nothing’s really happened with plan sponsors, because they’re just not ready to move into the alternatives. Chris: That’s probably a key point that real alternatives, if we all wrote down our definition of alternatives, we’d get five different answers. And you mentioned kind of low volatility or dividend oriented, defensive equities which we use. Those are basically an alternative in a glide path. Not many are using them. Global hedged bonds; these aren’t asset classes or inflation diversifiers. These aren’t alternatives in the sense of the word that you were using. But we don’t see them utilized broadly in glide paths. And in terms of minimizing interest rate risk or inflation risk, they can be really important. David: You see, I think a part of it is if you take this up a notch and think about why we are actually sitting here as practitioners of Target Date Funds that are inside Defined Contribution plans, we’re here because many of the employers have either de-emphasized or in most cases, eliminated their Defined Benefit plans. And if we were sitting here discussing what a participant would have gotten in his Defined Benefit plan, these type of investments would have been a staple in those plans. And the practitioners in the Defined Benefit space would say, “It’s okay not to have all of this, you know, level of, you know, this level of liquidity because we’re not going to pay out the benefits for a long time.” So here we are with a lot of people who have 30 and 40 year time horizons and we’re giving them daily liquidity. Maybe that too is not the most optimal situation when we’re thinking about very, very long time horizons. Peter Grant: What’s interesting, we’re all touching a little bit on the future of Target Date Funds, which is a question in our next segment. So I’m going to … let’s go into that a little bit more and hear, what do you all think is the future? We’ve spoke a little bit about the decumulation phase. We’ve talked about adding alternatives. So any other thoughts about the future, if we are here 10 years from now and perhaps the government gives more protections, what are the plans going to look like for Target Date Funds. Brad: I think there’ll be a wide range as there always are. And there is this range today. It appears for the last 10 years most of the assets in the industry have been in a handful — five, six, seven — large proven glide paths that are generally fairly straight down the middle that some use passive, some use active, but they’ve got pretty typical asset allocation. They use stocks and bonds. I bet that 10 years from now that will still be the vast majority of the industry. There may be other things that are more complicated. I bet that won’t be the majority of the industry. And the industry is going to be much larger in 10 years. We don’t know how many multiples of the 1.5 trillion, but it’ll be multiples. Peter Grant: Sean. Sean: Yeah. I think, I guess I’ll kind of … I’ll do three categories. One, I think you’re going to see more bespoke solutions. So the more pointed we can get in delivering outcomes for participants, the more we understand the participant populations of every single plan sponsor, the more we can launch these bespoke solutions with scale. So I think, you know, the more optionality we can give people to get more closely aligned with how we see, you know, population x saving and investing and retiring and how long they’re expected to live in their current industry, then the better we can deliver on the objectives that we all have for those participants. I do think decumulation is going to be something, that’s my second point that we’re going to see in Target Date Funds. And I think that’s going to be a great thing. You know, we need some first movers in that category. I think we need even more protection from Washington, as he implied, on the alternative side. And then three, I actually agree with, Chris, I think that if you look at where, you know, public markets are from a valuation perspective and from a future expected return perspective, even though on a 10 or 20 year basis, they are relatively muted compared to where we had been over the last 30 years. And so maybe accessing the private markets or, you know, again, defining alternative strategies is difficult across a table like this. But I think incorporating things like private market strategies would be attractive in a Target Date Fund. We have to get past liquidity issues. We have to get people comfortable with the pricing activity of those types of strategies. But I do think that in order to get more diversification, more growth potential for participants of all ages that you’re going to see more alternative type of asset classes in Target Date Funds. Peter Grant: Yeah, there are good companies in the private markets, you’re there as well. Chris, what would you add? Chris: I think we’ll see some trends continue. We’ll see less assets in the mutual fund from a plan sponsor’s record keeper, we’ll see more in custom. We’ll see more in collective trusts. I also think we touched on personalization a couple of times. I think there is a way to embed that personalization without requiring the engagement of a participant. Peter, if you’re a typical participant you’re simply unwilling to engage. But what if I could personalize your asset allocation? If I could obtain your salary, which I can, then I know your Social Security benefits. I can look at your savings rate. Do you have a DB plan? If so, what’s your benefit? Do you have company stock exposure or not? And what’s your accumulated wealth? I could use all that information. You haven’t had to engage and I could build you a personalized glide path and Target Date Fund. And how do I implement that? Well, maybe it’s just you normally would be in the 2030 fund and I’d move you horizontally to the 2015 or the 2040 fund. Or maybe I keep you in that 2030 fund and I have a completion fund of more equity or more defensively oriented fixed income, which could give you a personalized asset allocation. So it leaves the assets in the default and the Target Date Fund will, in my view, likely persist. But it allows us to personalize around that. Is that important to do when someone’s 25 or 30? Absolutely not, if we could do that when someone’s 50 or 60, that would be a vast improvement over what we’re doing today. Peter Grant: So that’s a really interesting point. Do you see your firms moving? That sounds more and more like a managed account type structure. Are your firms moving in that direction? Chris: I’d say for me, yes, but less a managed account. A managed account does a couple of things. One, it requires that engagement or else you’re tending to pay a pretty expensive price for a baseline asset allocation. Two, it typically requires you to use the options that are core to the plan. Well, I may want to have something in a multi asset class portfolio like a Target Date that I don’t want to give someone the opportunity to put all of their assets into. So I would call it a managed account light or call it a personalized Target Date Fund. It’s not managed accounts. But I would say it sits between that and the Target Date Funds today. Sean: Yeah. I think we’re in the same boat. And so there’s a lot of data out there on every single participant to the extent that firms are comfortable sharing that with the larger investment outfits. We can put together these types of strategies in a very convenient way. The more data we have the more precise we can get. And I think that’s going to drive some really good outcomes. And so, yeah, same managed account light. And then I think maybe the secondary part of that is delivering it through a platform, you know, that I think young individuals right now are utilizing. So if we can get them information through their phones, for example, that’s going to be very attractive for that younger population. And so, yeah, I agree, you know, utilize the data that we have to deliver these more personalized solutions, but then in a transparent and clean way get that data to people in their hands in the way that they want to consume that information. Peter Grant: And, David, I thought I read that ICMA-RC has a new calculator, retirement readiness that may have come out. And so maybe you can add your thoughts on this as well as the future. David: Sure. Well, we do and but I think when you think about how Target Date Funds are going to evolve over time, I think one of the ways is how we think about best practices. And I think you’re going to see more open architecture, more multi manager type of solutions than you see today. I think there is going to be more personalization. I think there’s going to be more customization. I think despite the experience that, you know, that BlackRock have, I think there will be more annuitization that will be tagged on to, you know, glide paths over time. And as we’ve mentioned, as everybody has mentioned, there’ll be a variety of new asset classes that somehow will find their way into these funds. Because I think there is going to be a lot of demand for, you know, for solutions in Defined Contribution plans that attempt at least to mimic, you know, some of the desirable aspects that are in DB plans over time. Peter Grant: So there is one topic we didn’t cover and that was the CITs versus mutual funds. So I’m going to circle back to that and see if you all want to add and then we’ll move on to our closing remarks. So, I know, David, we had spoken, you had some interesting things. David: Yeah. That’s an important thing for us. And I think that’s part of the evolution. We have moved away from mutual funds and toward Collective Trusts. And we think that over time that is a less expensive solution. And even more importantly, it’s a flexible solution. You know, you can make changes in your glide path and changes to underlying managers probably a bit more easily than you can with, you know, with 40 Act mutual funds. Peter Grant: Anyone else? Chris: I would view that as a secondary, but important decision. You know, make the decision that’s best for the plan or the plan that you’re working with. What’s the slope of the glide path that meets your needs? Do you want something that’s less well or more well diversified? Do you want active or passive or a mix of both? Do you want a closed architecture or an open architecture? And once you make that decision, if there’s both a mutual fund and a CIT available, you know, for some plans they’re too small. But for many that CIT may be able to deliver all the value of the mutual fund and do so more economically. But the main part of the decision-making should still be the glide path and the implementation. But we’ve seen a lot of growth. And I think we’ll continue to in CITs. David: Yeah. And we see a lot of the danger by fees, there’s… Brad: Well, I think it’s interesting, we have been struck watching the industry that fee dynamic with CITs. We currently don’t have a CIT, and but our six sort of lower share class mutual fund pricing on American Funds Target Date is about 40/41 basis points. And what we’re seeing is other mutual fund providers maybe at 60/65 basis points, and then they discount the glide path for their CIT down to actually about where we are on our mutual fund already. And so it’s been a dynamic where certain plan sponsors and employees are paying a lot more than they probably should be for the underlying funds. And then other people are getting a big discount. So hopefully that will normalize over time, and it probably means that the higher priced fee funds need to come down, mutual fund. And there is a little more flexibility. There are some clients and plan sponsors who really want to use that CIT structure, which is great. And I think it will grow. It’s growing a little faster than the mutual fund, but they’re both growing. And the mutual fund side is about twice as big. So I think they’ll be around both for a long time. Sean: Yeah. So we run both, CIT and mutual funds. I’d say the preponderance of our Target Date Fund franchise is in Collective Investment Trusts. And as mentioned, there’s size restrictions of course to access that versus a mutual fund. And some plan sponsors are uncomfortable with the fact that, hey, my participant can’t go onto Yahoo Finance or Google Finance and type in a ticker to get their information. So there are some problems. I mean from a regulatory perspective the reporting requirements are equivalent. So that kind of goes away when people are invested in one of the two vehicles. The benefit, of course, on the larger end, if you are in a CIT you do have benefits of scale. And so from our perspective if you can save on things like transaction costs, which on our platform is a benefit of being in that CIT structure, you think if, Peter, if you’re buying into your 401(k) every two weeks when you get a paycheck, if we can take basis points off the table from a headwind perspective, you’re going to accumulate more assets at the end of the day. And so that’s why we tend to see people that are CIT eligible, or Collective Investment Trust eligible, go that direction for the cost savings that you mentioned. Peter Grant: Well, Target Date Funds, there’s no doubt they’re an important part of the financial wellness package, that Defined Contribution plans in our entire industry is looking to solve for. And I think we’ve touched on a number of the complicated issues and the fact that we obviously don’t know where the evolution is going. But I think all of our firms are dedicated to try to bring more and more value to help folks towards retirement. So I’d appreciate hearing any closing remarks you’d each like to add and then we’ll wrap up the class. So, David, we’ll start with you and work down. David: Sure. As we’ve all said, Target Date Funds are typically a default option. They’re increasingly popular, as you mentioned, well over $1 trillion now. And it’s up to, I think, all of us collectively to make sure that meets the needs of the typical participant. I would add though, it can’t meet the need of every participant. And it’s still incumbent upon each individual investor as a participant to say, “When is my situation a bit different than what may be typical?” You are the one who has the inside information on your own retirement. So if you’re in a 2030 fund, but you think you’re going to retire much earlier than that, or you have substantial assets on the side, there’s nothing that prevents you from, you know, having your own management of your own account. If you want to and you want to do a set it and forget it, the Target Date Funds are a great place, if you think that you’re a rather typical investor, because it’s built for the typical investor, or even most investors, but not every investor. Peter Grant: Chris. Chris: Target Date Funds have been a really good option. They’ve added a lot of value to participants above and beyond what they could have done on their own. But I still think they need to get better and they will get better. And I think we’ll see more diversification from an asset class point of view. We’ll see more mixes of active and passive. And we’ll see more open architecture versus what we have today. Again, what we see in other forms of investment management. I see that more as a near term evolution of Target Date Funds. I think as time goes on we’ll see more personalization and we’ll see more embedded income options. I won’t say necessarily into a Target Date Fund, but into a default strategy. But I think those will take a little bit longer to work their way into the QDIA. Sean: Yeah. I’d say broadly, retirement success, and I’ll define that as making sure people can retire on time and have the lives that they want in retirement, comes down to the savings problem that we discussed and then being invested in the right vehicle. We all have that, the investment vehicle that’s going to get participants to a good spot, assuming they can get the savings rates that are necessary. So I think we can talk about the evolution of Target Date Funds all we want. But I’d go back to that partnership amongst a plan sponsor, a consultant, along with the investment manager to deliver the communications necessary to participants to say, “We need to get you invested. We need to be increasing your savings rates as you’re moving through your accumulation years. And then you need to stay invested so you can realize the benefits of these professionally managed strategies.” And I think when you have a confluence of those events then you’re going to have really good outcomes for participants. And so I think we’re all probably aligned in that mission and so, and agree, the evolution of Target Date Funds is only going to support that effort. But everything coming together is really important. Brad: I’d echo all the thoughts. You know I think it’s been a phenomenal 10 or 15 years. In my whole career I think this is one of the most impactful and effective things that’s ever happened to the investment industry for regular folks. So it’s very exciting. It’s still early days in the industry. And so I think, again, I just wanted to thank everybody for a great discussion. Thank you and Asset TV for doing it. Thanks to all the advisors out there doing work on this area. And we are very excited for how this can help real people. Peter Grant: Well, thank you all for sharing your perspectives today, it was definitely very interesting to hear the different viewpoints on various topics. And that concludes today’s Masterclass. Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value. The statements expressed herein are based on the date noted. Statements also include the opinions and beliefs of the speaker(s) at the time the commentary was recorded and are not intended to represent the opinions and beliefs of the speaker(s) at any other time. This information is intended merely to highlight issues and is not intended to be comprehensive or to provide advice. Permission is given for personal use only. Any reproduction, modification, distribution, transmission or republication of the information, in part or in full, is prohibited. Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses and summary prospectuses, which can be obtained from a financial professional and should be read carefully before investing. Information provided on this website is intended for use by financial advisors and institutional investors. Securities are offered through American Funds Distributors, Inc., member FINRA. The Capital Group companies manage equity assets through three investment groups. These groups make investment and proxy voting decisions independently. Fixed income investment professionals provide fixed income research and investment management across the Capital organization; however, for securities with equity characteristics, they act solely on behalf of one of the three equity investment groups. Although the target date funds are managed for investors on a projected retirement date time frame, the fund's allocation strategy does not guarantee that investors' retirement goals will be met. American Funds investment professionals 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. The target date is the year in which an investor is assumed to retire and begin taking withdrawals. Investment professionals continue to manage each fund for 30 years after it reaches its target date.