Library

You often hear people say ‘what a difference a day makes’ to highlight how quickly things can change. When it comes to the stock market, it may be better said ‘what a difference a decade makes’. Investors over the past 20 years have experienced a wide range of markets starting with the ‘lost decade’ from 2000 – 2009 followed by one of the longest bull markets in history from 2010- 2019. These diverging decades likely led to vastly different retirement outcomes for participants. For example, based on the median target date fund (TDF) returns intended for those within ten years of retirement at that time, participants either barely broke even over the course of the 2000s or more than doubled their retirement nest egg over the most recent decade. If the adage holds true, the next decade will certainly be different than the last.

We highlight TDFs because for retirement plan sponsors, advisors and participants, the past two decades also coincides with the emergence and growth of this investment solution. TDFs were available in the early 2000’s but their use and breadth of offerings exploded with the creation of Qualifi ed Default Investment Alternatives (QDIAs) as part of the Pension Protection Act of 2006. They quickly became the favored QDIA choice for their ease of use and ability to help address well established participant behavioral challenges.

Just as TDFs started to gain traction in the QDIA role, the Global Financial Crisis hit and erased significant wealth for a wide range of investors, including participants using TDFs. Even those invested in 2010 funds – vintages that should be fairly conservative given how close they were to their target year – saw losses as severe as -49%. The range of losses among TDFs during this period of time, illustrated below, highlight the fact that there were material differences in investment philosophies and objectives. As importantly, it also brought to light the need to ensure a plan’s TDF solution provides a good fit for participants through both good and bad times. In fact, during 2013, the Department of Labor issued guidance in selecting and monitoring TDFs, urging plan fiduciaries to fully examine the principal strategies and risks of a prospective provider’s approach to TDF investing.

The decade since the Global Financial Crisis has been more favorable for participants, characterized by strong returns and low volatility for equities, which has propelled average 401(k) balances to record levels. There are important implications of this market environment for plan fiduciaries as well. Since due diligence programs are commonly based on standard trailing time periods, such as three and five year intervals, today’s performance snapshots are bull market biased. In fact, given the duration and magnitude of this bull market run, the trailing 10-year time period now reflects a generally one-directional market environment.

While providing adequate growth is a critical aspect of helping participants reach their long-term objectives, it is important not to lose sight of the impact capital losses can have during market downturns. Drawdowns are disadvantageous from a mathematical perspective as a greater gain is needed to offset a loss, but they are also impactful from a behavioral standpoint. Behavioral finance insights over the past few decades have made it clear that participants who are invested more aggressively than their risk tolerances dictate are more likely to engage in damaging yet avoidable behavior, such as selling their investments at unfavorable prices during market downturns and buying back in only after the market has rebounded and appreciated significantly. As a result, participants may have a more difficult time staying the course and ultimately achieving their retirement goals.

The temptation to do the wrong thing at the wrong time only increases for many participants as they near retirement. This type of response during stressful market events is understandable. Losses become increasingly larger in dollar terms as balances grow, and the reality of having fewer years to make up any lost ground begins to set in. In fact, as illustrated below, a survey found that 77% of investors support managers protecting their portfolios from losses, even if it results in periods of underperformance. As you would expect, this desire was strongest among older respondents who are closer to retirement.

Participants’ views on the risk/reward balancing act are important for plan fiduciaries to keep in mind as they select and monitor their plans’ TDFs. Assets intended for participants nearing or in retirement have swelled. Specifically, TDF assets in vintages near or in retirement have grown significantly since the Global Financial Crisis, exceeding $550 billion at the end of 2019. With these assets experiencing an increase of over 800% since 2007, the next market downturn may have a much larger impact on this group of participants that can least afford to suffer significant losses. It’s worth noting that this asset figure doesn’t include plan assets managed in Collective Investment Trust (CIT) vehicles. It’s been well documented that target date CITs have experienced tremendous growth over the past decade as well.

Source: Morningstar, Inc. Analysis by Manning & Napier. Unless otherwise noted, data as of 12/31/2019. The TDF Universe includes all mutual funds categorized as target date funds by Morningstar. 

*Defined as vintages within 10 years of their identified target date.

Of the growing TDF asset base, our analysis indicates that over three-quarters is invested in five TDF families. While there are likely many reasons that these TDF providers have been successful in growing and/or retaining their market share, a notable commonality among them is that, on average, they are governed by higher equity glide paths. Due in part to their glide path positioning, these TDFs have, on average, outperformed more conservative counterparts during this extended bull market run.

Source: Morningstar, Inc. Analysis by Manning & Napier. Unless otherwise noted, data as of 12/31/2019. The TDF Universe includes all mutual funds categorized as target date funds by Morningstar.

That stated, during an equity market downturn, TDFs governed by higher equity glide paths may have difficulty meeting the needs of risk averse participants, as well as those that are relying on retirement assets to support daily living expenses. Given the significant increase of assets in near retirement vintages, the stakes are much higher for TDF providers to help participants successfully navigate the next inevitable downturn. Consider that during the Global Financial Crisis, the five 2010 funds with the highest allocations to equities lost, on average, over one-third more than the remaining funds within their peer group.

Source: Morningstar, Inc. Analysis by Manning & Napier. Unless otherwise noted, data as of 12/31/2019. 

*Defined as 11/01/2007 - 02/28/2009, including any funds that have since been liquidated.

Conclusion

This decade has provided a generally favorable market backdrop for participants to build and spend down their retirement wealth. However, one doesn’t have to look any further than the decade before to recall much more challenging times. Given the uncertainty of future market environments, plan fiduciaries should be diligent to weigh participant behavioral realities, look beyond bull biased trailing time periods, and incorporate additional metrics such as maximum drawdown and downside capture ratios to evaluate a TDF manager’s ability to protect retirement assets during periods of volatility. By adopting a well-balanced due diligence program that considers a manager’s ability to both grow and protect assets, plan fiduciaries can further document that the chosen TDF solution is structured to meet the needs of their participant base through a variety of market conditions.

Manning & Napier Investor Services, Inc. is a member of FINRA.

Morningstar, Inc. is a global investment research firm providing data, information, and analysis of stocks and mutual funds. ©2020 Morningstar, Inc. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied, adapted or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information, except where such damages or losses cannot be limited or excluded by law in your jurisdiction. Past financial performance is no guarantee of future results.

¹Source: Ignites, September 2017.