What Can Participants Teach Us About Target Date Funds?

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  • 27 mins 23 secs
Sean Kenney, Jessica Sclafani and Joe Flaherty discuss the landscape of the DC and Target Date world in Q2 2020.

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What Can Participants Teach Us About Target Date Funds?

Sean Kenney, Jessica Sclafani and Joe Flaherty discuss the landscape of the DC and Target Date world in Q2 2020.

Sean Kenney:

Welcome, everybody, and thank you for joining our second quarter review on the DC and Target Date landscape. I have to admit the past quarter's felt a little bit like Groundhog Day as many of us remain largely quarantined and working from home. But despite that, the second quarter was anything but ordinary. We saw a lot of action both in terms of the capital markets as well as in the retirement industry in general. In addition, I think many of us can empathize with many Americans that continue to face challenges that put stress on their financial security. Many workers remain unemployed or furloughed. Others have seen their wages or work hours reduced, or even their company profit sharing reduced or eliminated. Even for those who are fortunate enough to have full time employment, the uncertainty is unprecedented, particularly for those who are close to retirement age.

Sean Kenney:

So for all of us whose goal it is to help people achieve financial security and meet their retirement goals, this is actually an important time for us to listen to what participants are thinking, feeling, and expecting going forward, and that's really going to be the focus of today's webcast. To do that, we're excited to share with you the results of our 2020 participant survey. It focused on a number of topics relevant to DC participants today and plan sponsors and advisors, and the results give us a glimpse into what participant perceptions and expectations are across a variety of topics, including Target Date funds. We hope you will find this valuable and help you perform your quarterly reviews.

Sean Kenney:

Thankfully I'm joined by two experts on these topics who are in a position to help us do exactly that, Joe Flaherty, who's a portfolio manager on our target date suite, the lifetime funds, and he's also our chief investment risk officer, as well as Jessica Sclafani, who's our defined contribution strategist and an expert on the DC markets.

Sean Kenney:

Jessica, maybe as a starting point, I could ask you to spend a minute just describing the survey so the folks listening have an idea of the topics we focused on and who was targeted in the survey.

Jessica Sclafani:

Sure thing. Thanks, Sean. Our proprietary 2020 DC participant survey was fielded earlier this year in April. To qualify for participation in the survey, survey respondents had to be 18 or older, working at least part-time, and actively contributing to an employer-sponsored DC plan. We ended up with a total of 1005 survey respondents in the US. In terms of topics, the survey really focused on three key areas: target date funds, sustainable investing or ESG, and then also participant behaviors around market volatility and risk. For our conversation today, we'll focus on the survey results related to target date funds to help us understand how participants are thinking about target date funds and how that may or may not align with the realities of how target date funds are actually constructed.

Sean Kenney:

That's helpful background. Thanks, Jessica. And given our focus is on target date funds and they continue to be the default investment of choice today, maybe we could start the discussion today by sharing what our survey results are telling us about why participants are choosing target date funds.

Jessica Sclafani:

Sure. Following the passage of the Pension Protection Act of 2006 and the ensuing QDIA guidance from the Department of Labor, we've seen target date funds dramatically increase both their prevalence and assets in the DC market. As we're showing you here, specifically target date funds now represent greater than one quarter of total 401k plan assets, and 58% of 401k plan contributions are now being directed to a target date fund. We are all probably pretty familiar with this data and well-versed in all of the reasons why target date funds were able to take the DC market by storm.

Jessica Sclafani:

So for a slightly different take on this, we thought we'd ask the participants why they chose to invest in a target date fund. And I'll just quickly note before we dive into the data that the survey respondents could select more than one option here, so the percentages that you see, they won't total to a hundred percent.

Jessica Sclafani:

So let's go ahead and dive into the results. Capturing greater than one third of respondents, we have "I choose to use a mix of investment options in order to diversify" at the top of the list. We interpret this as a positive data point as it indicates participants are generally aware of the value of diversification. The second most commonly selected response is "The target date fund was recommended by a financial advisor or my plan administrator", capturing about 28% of survey respondents. This demonstrates the influence of each of these parties in directing participant assets to target date funds. With just greater than one in four survey respondents or 26%, we have "Target date fund seemed easiest to use." This reflects the intentional design of target date funds as a one stop shop solution for participants. Interestingly, we see that only 21% said they were defaulted into the target date fund.

Jessica Sclafani:

Admittedly, I'd say this feels a bit low and it might reflect participants perhaps not fully understanding that they were automatically enrolled into a target date fund. From a quantitative perspective, as opposed to this more qualitative view that we're looking at here with survey data, we know that automatic enrollment into a target date fund is one of the primary drivers powering target date asset growth. And the last thing that I'll point out here is that fees, or as the survey phrased it here, "the target date fund look like the cheapest option" was actually the least commonly selected response, which really runs counter to what we often hear about participants "wanting the cheapest options."

Sean Kenney:

Yeah, those are interesting results. And on the one hand, it's encouraging to see participants invest in target date funds because they're likely to be invested in a thoughtfully constructed asset allocation over their journey. But on the other hand, it does beg the question if participants really understand how target date funds work or are they just following the advice of their advisors or defaulting into the plan?

Jessica Sclafani:

Sure. So our survey data did offer some insights on that point. And what we've learned is that the majority of participants feel as though they understand how their target date fund works. However, when we further delve into this topic, a few key fundamental misunderstandings emerged that really we should all be aware of. Starting on a positive note on the left hand side of the slide, the good news, we see that around 70% of respondents across the three age cohorts that we're showing you understand that their target date fund evolves to become more conservative as they get closer to retirement. This is accurate. This is good. Also, we see the importance of diversification resurfaces here with a majority of respondents across the three age cohorts agreeing with the statement "They are an easy way for me to diversify with one investment."

Jessica Sclafani:

Now we'll move to the not so good news on the right hand side of the slide and I just want to caveat here that the point of highlighting the survey data is not to throw our hands in the air and say, "Participants don't know anything." Rather, our goal is much more constructive and that we want to gauge where participants do understand target date funds, and also identify where there might be misperceptions and gaps in knowledge that we can address. So for example, a large percentage of respondents strongly agreed or somewhat agreed with the statement "Target date funds provide me with a guaranteed rate of return." We all know this isn't the case. I would point out that on the bright side, this percentage declines looking at the 50 plus age cohort, but it's still sizable at 39%. Similarly, we also see a large percentage of respondents indicate that they believe their target date fund provides them with a guaranteed stream of income at retirement.

Jessica Sclafani:

Again, focusing on that age 50 plus cohort, we still have nearly half, or 49% of respondents, that strongly agree or somewhat agree that their target date fund will provide them with a guaranteed stream of income in retirement. This is clearly troubling. Both of these data points indicate that a large percentage of participants mistakenly believe that their target date fund includes some sort of guarantee, whether it's the return or the stream of income in retirement. And the last point I'll make here, shifting gears a little bit, we see that we have 42% of the age 50 plus cohort agree with the statement, "Target date funds invest entirely in cash or other low risk investments once I'm retired." And certainly when we look at the universe of target date funds, we all know this statement really. Isn't true.

Sean Kenney:

Yeah. Those are really interesting. And particularly you've got the word guaranteed in there, which got a lot of respondents positively responding to it, as well as the word entirely moving to cash or low risk investment. So it leads me to believe as we interpret these results that maybe DC participants have a different definition of what conservative is compared to the way target date fund asset allocators or portfolio managers are thinking about conservative.

Sean Kenney:

So I'd be curious, Joe, what your reaction would be to these results.

Joe Flaherty:

Yeah, thanks, Sean. There was a clear mismatch between getting more conservative and providing a guaranteed stream of income or rate of return. And while conservative is in the eye of the beholder and each participant gets to make their own determination. As Jessica mentioned, there are no target date funds that invest entirely in cash or other low risk investments in retirement.

Joe Flaherty:

And that's because target date providers recognize the need for not only protecting balances as one approaches retirement, but also the need for providing growth potential so that a participant can maintain his or her standard of living throughout that retirement. Having said that, lowering the potential for capital losses and maximizing the potential for capital growth are competing objectives and different target date providers place different levels of emphasis on each leading to a wide range of asset allocations when one reaches the target date. So it's important to understand what you own as a participant. We see a wider range near the target date than we see in the early years, where there's generally more agreement on the emphasis for growth given long time horizons. There's roughly a 50% range in terms of fixed income allocation at the target date among the 25 largest mutual fund target date providers, from a low of roughly 40% to a high of roughly 90%.

Joe Flaherty:

The MFS lifetime income fund is toward the upper end of this range at 71% because we place greater emphasis on reducing the potential for capital losses. We believe that higher levels of equity in the later stages of the retirement journey expose participants to excessive draw downs and sequencing risk. Sequencing risk because as participants approach that retirement date, they have less time to recover from a significant drop in assets, which can have a major impact on the quality of the retirement. So there's more conservative positioning that we've assumed is I would say more consistent with the conservative expectations of participants.

Sean Kenney:

Yeah, that's helpful context, Joe. And those dual objectives are certainly something that both target date providers and then plan sponsors have to square with the participant base. So that's insightful from the survey results. But now that we have an idea of what participants understand and expect from the target date investment, maybe we can shift gears a little bit, Jessica, and think about the responses we got that were some of the top concerns on the minds of participants.

Jessica Sclafani:

Sure. So we'll come back to our survey data. And on this slide, we're showing you the results for the 50 plus age cohort specifically, this will allow us to focus on participants who are approaching retirement and really need to engage on the topic of retirement. So what we did here is we presented survey respondents with many choices in terms of what their top concerns might be in retirement. And then we asked them to rank order their top three. And we're showing you the top three here. As you can see, the top three concerns all relate to this fear of not having saved enough for retirement, whether it's a result of longevity risk, under saving, or market volatility.

Joe Flaherty:

If I could jump in here, Sean, longevity risk is a valid concern as many participants have accumulated insufficient savings and are carrying too much risk heading into retirement, but one can not fix chronic undersaving by taking additional risk. The problem is that the topic of longevity risk does not typically come to the forefront until a participant approaches retirement. Proper management of longevity risk really needs to start at the beginning of the retirement savings journey, not at the end. Saving at a sufficient rate from a young age, investing with an emphasis on growth can lead to a bigger balance as one approaches retirement. A bigger balance reduces the need or temptation to take excessive risk in an effort to try to catch up, allowing target date providers in participants to properly place greater emphasis on that protection against capital losses.

Joe Flaherty:

The concern around volatility negatively affecting savings seems focused on the fear of large capital losses doing irreparable damage to one's retirement balance at or around retirement. So tied into that same longevity risk concern. This can best be managed through that more conservative asset allocation as one approaches retirement, but there's another hidden cost of volatility that exists throughout the entire retirement journey known as volatility drain. All else being equal, higher volatility of returns leads to lower compound rates of return or growth. One way to reduce volatility and improve risk adjusted performance and thus compound rates of return and growth is through broader diversification, which can reduce overall portfolio volatility at given levels of return.

Sean Kenney:

Thanks for jumping in there, Joe, because I do reflect on the industry. We spend a lot of time educating participants about longevity risk, but it tends to be as participants get older. But to your point, it really should start at the beginning of the savings journey because then they may have less of a need to try to out invest a lack of savings as they get older. So I think that's an important point and a core takeaway as people think about the way target date funds are constructed and the way we're communicating risk along that journey. I might transition over to Jessica here, again, to talk a little bit about what participants consider to be the most important characteristics in target date funds, given the perceptions that they have.

Jessica Sclafani:

Sure. So here we asked survey respondents to identify what they consider to be the most important characteristics of a target date fund and the data that we're looking at on this slide, I'll just point out represents responses from across all age cohorts. Consistent with we learned from the other target date fund related survey questions that we walked through earlier, we see that participants really value the ease of use when it comes to target date funds. From there, we see diversification emerge as highly valued and this makes sense that target date funds were designed to be an easy one stop solution that dynamically evolve in terms of asset allocation as participants age and their risk tolerance shifts. For me, these results are overall reassuring as they aligned with the original intent in creating target date funds. That is that they be easy to use and dynamic without requiring the engagement of the participant.

Jessica Sclafani:

So now moving on to results related to time horizon, we see that the data is actually somewhat surprising, albeit in a positive way. Results show that survey respondents are actually prioritizing longterm investment performance, defined here as greater than five years, over a short term investment performance. If you think about it, this doesn't really align with how target date funds are often reviewed and monitored. Hold on honey. We encourage plan sponsors and advisors to think about how this survey data which represents the participant perspective aligns with their ongoing monitoring process for target date funds.

Sean Kenney:

Joe, I'm curious if you have any thoughts coming off of that.

Joe Flaherty:

Yeah. Maybe I'll touch a little bit more on diversification. I talked about the concept of volatility drain and the importance of diversification leading to better risk adjusted performance and better growth all else being equal over time. But one thing I want to highlight is not only do asset classes come in and out of favor, but segments of markets also exhibit rotations in terms of leadership. Over the last decade, since essentially the bottom of the global financial crisis, within equity, large cap has dominated small cap, growth has dominated value, and the US has dominated the rest of the world. We've seen something similar in fixed income, where longer term debt has outperformed shorter term debt as rates have generally been declining. Credit is performed well alongside equity. And the US has outperformed the rest of the world aided by a stronger dollar.

Joe Flaherty:

Throughout this decade, broad diversification has actually been a headwind as the markets have favored portfolios that are concentrated in US large cap equities and Bloomberg Barclay's ag-like fixed income portfolios, but we know that markets move through cycles. And while this trend has felt extended, it will not continue on indefinitely. History has shown that through a full market cycle, broad diversification leads to that better risk adjusted performance. Year to date, we've seen similar shifts in leadership as is often the case when we get extreme market moves in opposite directions like we witnessed in Q1 and Q2. During the equity downdraft in February March, we saw large cap equity holding better than small cap equity as is often the case. During the rebound, we've seen a stronger bounce back in small cap, even with the continued dominant performance of some of the largest tech names.

Joe Flaherty:

We've seen something similar play out in developed equity markets versus emerging equity markets yet less extreme with developed markets holding in marginally better in the sell off in emerging markets out performing in the rebound. Within fixed income, we saw the higher returning higher risk, more credit-based segments of the markets underperform the more interest rates sensitive segments of the market in Q1, and then subsequently outperform alongside the equity rebound in Q2. So as we think about funds. Sorry, go ahead.

Sean Kenney:

Well, I was going to say Q1 versus Q2 gave us a pretty good tale of two cities, right? Where in the first quarter's webcast, we highlighted the fact that there was a bit of a diversification headwind and being really broadly diversified across these different asset classes and sub-asset classes was a bit of a headwind versus Q2 where it reversed and became a bit of a tailwind. And typically we don't see reversal that quickly, but it's a interesting kind of two quarter period.

Joe Flaherty:

Yeah. And so the takeaway there is not only do we see these rotations in leadership and evolution of leadership over the longterm, but we can also see some pretty dramatic shifts in the short term. And these inflection points are really hard to identify in advance. So if we know that, how can we best protect the portfolio from being overexposed to those segments of the market that suffer most in a particular environment and how do we ensure that the portfolio has exposure to those segments of the market that actually performed best? And the simple answer is through broad diversification. Having said that, there was a wide range of diversification within equity and fixed income components of target date portfolios throughout the target date space. From portfolios to choose to concentrate in a single broad based index or a particular segment of the market to those that choose to offer a broad range of offerings that span many of the dimensions of risk that exists the broader asset class.

Joe Flaherty:

Our lifetime target date portfolios are designed to provide a second layer of diversification within asset classes, along multiple dimensions of risks, through the incorporation of close to 30 underlying funds. The portfolios are diversified by geography, capitalization, style, credit quality, interest rate sensitivity, and investment process. We see broad diversification along the entire retirement journey while adhering to our philosophy of emphasizing capital appreciation in the early years, and gradually shifting that emphasis to protection of capital in the later years. We allocate more relative weight to underlying funds that offer greater return potential but come with greater risks, such as smaller cap or emerging market equity, high yield, and emerging market debt in the longer dated portfolios intended for early savers. We allocate more relative weight to underlying funds that tend to come with less relative risk, such as larger cap equity, government securities, or limited maturity debt in the shorter dated portfolios intended for retirees. The mix of underlying funds gradually evolves along the glide path from the more aggressive positioning at the far dated end to the more conservative positioning at the near date end.

Sean Kenney:

I'm glad you spent some time on that Joe, because diversification seems like a fairly basic topic when you think about target dates funds, but as we highlighted earlier, there is a wide range of diversification across different target date fund offerings. And what we also learned from Jessica and the survey results is that clearly diversification is a core reason why participants perceive to want and value target date funds. So it's clearly an important topic. And as a portfolio manager of a lifetime funds and more broadly as a risk manager, I think your perspective is helpful there. And you've highlighted the asset classes within the asset classes and the way you think about building the risk budget across the participant journey, which I think is a helpful framework for us to build off. Maybe you could spend just a few minutes as we wrap up here talking about performance of the lifetime funds. And if I could ask you maybe to make a few comments around both the short term performance and really speak to maybe the first couple of quarters that we've talked about, but then also frame that more in the longterm for our listeners.

Joe Flaherty:

Yeah, certainly. We talked about some of the dynamics that took place Q1 versus Q2 in terms of segments of the markets that are performed and underperformed. And first, let me say that the performance over both the longterm and short term is consistent with design and expectations given the environment that we've been through. Shorter term relative performance is largely a reflection of the drawdown experience in Q1. So I wonder if this is a lifetime near dated portfolios with greater emphasis on protection of capital than many of our peers held in better through the equity market sell off. And despite this sharp rebound that we've seen in Q2, equity markets have not yet fully recovered. As such, the shorter term performance has been better for these portfolios relative to their Morningstar category average. MFS's lifetime far dated portfolios, with greater emphasis on capital appreciation, higher risk profiles, less concerned with limiting short term volatility given the long time horizons, have actually underperformed through Q1, as we would expect. And this drives the year to date and one year relative performance.

Joe Flaherty:

But over the long term, what I think is important is we see the benefits of broad diversification. We see the benefits of disciplined portfolio management, and we see the benefits of active management as all of the portfolios along the entire glide path outperform them Morningstar category average over trailing three, five and 10 years.

Sean Kenney:

Great, thanks Joe. And thank you both you to Joe and to Jessica as well for giving some perspective on what participants are thinking and translating the survey results for our listeners. To close the call out, maybe I'll recap a few key themes that I think came clearly through in your comments. One is we continue to believe diversification along the journey is essential. It's clearly on the minds of participants. We saw that in the survey results, and we also know that diversification across different target date funds is quite different. So we always urge plan sponsors, advisors, consultants to dig in and really understand the exposures and the sub exposures within your target date fund suite.

Sean Kenney:

The second is that there's clearly a mismatch between what being conservative is in the minds of participants, particularly as they approach retirement, and the way many targeted funds are constructed. And as an industry, we talk so much about the longevity risk as people get closer to retirement and talk about equity exposure and the need to have continued growth as people approach retirement. But really as Joe highlighted, that's a conversation that should start really from the beginning and highlight why equity exposure early on really helps to address longevity risk later on, so the need to take substantial equity risk as you approach retirement becomes less and less as you save more.

Sean Kenney:

And then finally, as we always say at MFS, we encourage you to focus on the longterm. We talked about some short term performance, Q1 versus Q2, and the tale of two cities in terms of the diversification benefit, but it's always important we believe, particularly in the DC market where participants are investing over such long periods of time, to put the short term into the longterm context. So we're certainly here to help you do that and to help frame that conversation with participants. So we hope that the discussion today gave you a bit of a glimpse into how some of the perceptions and expectations of participants have translated today and what that means for target date funds. And we want to thank you for joining, thank you for your confidence in MFS, and be well.