The Ins and Outs of Target Dates Funds & the TSP Lifecycle Funds

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Dr. Barbara O’Neill

Dr. Barbara O’Neill, financial resource management specialist for Rutgers Cooperative Extension, has been a professor, financial educator, and author for 35 years. She has written over 1,500 consumer newspaper articles and over 125 articles for academic journals, conference proceedings, and other professional publications. She is a certified financial planner (CFPO), chartered retirement planning counselor (CRPCO), accredited financial counselor (AFC), certified housing counselor (CHC), and certified financial educator (CFEd).

Workshop Objectives- Part 1

§  Learn background, history, and characteristics of target date funds

•  Learn advantages and disadvantages of target date funds

•  Learn the difference between target date (lifecycle) funds and lifestyle funds

•  Learn how glide paths work

•  Learn about target date fund resources

Question: Do you invest in target date mutual funds? If so, which one(s)?

What is a Target Date Fund (a.k.a., Life-Cycle Fund)?

•  Diversified mutual fund portfolio consisting of 3 asset classes: stocks, bonds, cash equivalents

•  Asset allocation automatically adjusts; becomes more conservative (less stock) over time

•  Typically “fund of funds” with underlying funds from the same fund family

– Vanguard Target Retirement Funds

– Fidelity Freedom Funds

– Thrift Savings Plan (TSP)

Target Date (Lifecycle) Funds vs. Lifestyle Funds •  Two different types of mutual funds that are often confused

due to similar names

•  Both are “all-in-one” portfolios containing several different asset classes

•  Target date (Lifecycle) funds have a future date in their name and automatically adjust from an aggressive to a conservative asset allocation over time

•  Lifestyle (a.k.a, target risk) funds have different portfolios with different asset allocation % weightings; investors choose a portfolio to match risk tolerance level; portfolio won’t adjust over time (investors would need to change portfolios)

Lifecycle (Target Date) vs. Lifestyle Funds

Lifecycle (Target Date) • Manages money toward an investor’s future target date • Takes the guesswork out of the process of reducing investment risk over time • Low maintenance approach

Lifestyle (Target Risk) • Manages money according to investor’s risk tolerance level • Provides more consistent exposure to a certain amount of risk over time • Requires investor decisions and action to make changes

Distinguishing Trait: Mutual Fund Name

Lifecycle (Target Date)

•  Generally identified by a DATE in their title

•  Examples: 2020 fund, 2030 fund, 2050 fund, etc.

Lifestyle (Target Risk)

•  Generally identified by a RISK LEVEL WORD in their title

•  Examples: Growth Fund, Moderate Growth Fund, Conservative Growth Fund, Income Fund (Vanguard)

Selected Trade Names Lifecycle (Target Date)

•  Vanguard Target Retirement Funds

•  Fidelity Freedom Funds

•  T. Rowe Price Retirement Funds

Lifestyle (Target Risk)

• Vanguard LifeStrategy® Funds (4 portfolios)

• Fidelity Asset Manager® Funds (7 portfolios)

• T. Rowe Price Personal Strategy Funds (3 portfolios)

More About Target Date Funds •  Also referred to as “age-based” funds

•  Target date is the year an investor plans to retire and stop making new deposits to fund (+/-) 5 years

–  Dates spaced at 5- or 10-year intervals (2030, 2035, etc.)

–  If retiring in between two target dates, can choose one or the other nearest date or a combination of two close dates

Example: If planning to retire in 2022, could use a 2020 fund or 2025 fund or both

–  If a conservative investor, “go shorter” (2020)

–  If an aggressive investor, “go longer” (2025+; more stock )

Sample Target Date Mutual Fund Portfolios

More About Target Date Funds •  Equity and fixed-income assets in one mutual fund

•  Vanguard and Fidelity are two largest suppliers of target date funds; composition and expenses vary

–  Vanguard includes passively managed (index) funds

–  Fidelity includes actively managed funds

•  Only make sense if they include most of your retirement investments

–  Otherwise, you alter your overall asset allocation and contradict the whole premise of using TDFs

More About Target Date Funds •  Have gained popularity in last decade •  Popular “qualified default investment

alternative” (QDIA) for tax-deferred employer retirement plans

•  Typically formed as open-end investment companies •  Defining characteristic is glide path, which determine

asset mix of the fund over time

More About TDFs as QDIAs •  Default investments are especially important in

employer retirement plans with automatic enrollment

•  Some employees who are enrolled in employer retirement plans fail to provide instructions for investing their deposits

•  If workers do not select investments for their retirement account, employer puts money in the default investment

•  U.S. Department of Labor approved TDFs as an appropriate Qualified Default Investment Alternative

The Glide Path is Critical! •  Determines starting target date fund asset allocation

and how quickly it will change

•  Generally becomes more conservative over time

•  Three key elements:

–  Initial equity allocation

–  Slope of the glide path

–  Equity landing point (i.e. date after retirement when the equity-to-fixed-income ratio remains unchanged throughout rest of retirement)

http://www.pionline.com/article/20140818/PRINT/308189983/some-target-date-funds-are-boosting-equities

Glide Paths Vary Among TDF Providers

•  Glide path: how equity (stock) % changes over time; a critical determinant of wealth creation outcomes

•  Found in both TDFs for retirement and age-adjusted portfolios in 529 college savings plans

•  Each TDF provider establishes its own glide path and glide paths can vary considerably

•  Three glide path methods: –  Straight line: Steady, linear approach to gradually reduce stocks

(Vanguard and TIAA-CREF)

–  Stepped: Equities allocation is periodically adjusted in stages (ING)

–  Rolldown: High equity level until about 20 years before retirement and then a sharp reduction begins (Fidelity)

http://www.bogleheads.org/wiki/Glide_paths

Glide Path Illustrations Straight Line

Stepped

Rolldown

Source: http://www.bogleheads.org/wiki/Glide_paths

“To” and “Through” Glide Paths •  “To” Glide Path- Assumes that retirement age is the

target date; at that point, the portfolio’s stock % and investment mix remains static

•  “Through” Glide Path- The equity allocation continues to decrease for a designated number of years after retirement before leveling off

•  Landing Point- The point in the glide path where the TDF reaches its lowest equity allocation

•  TDFs with different glide paths and landing points have very different risk profiles

Through Retirement TDF With 25 Year Stock Landing Point

Source: U.S. Securities and Exchange Commission

TDF Industry Examples http://www.wealthinformatics.com/2011/04/17/do-you-know-your-target-retirement-funds-glide-path/

Describes starting equity %, type of glide path, and equity landing point for five TDFs • Fidelity Freedom • Vanguard Target Retirement • T. Rowe Price • TIAA-CREF • ING Solution

More About Target Date Funds •  As an “all-in-one” investment, should have exposure

to wide range of asset classes

–  Fidelity uses 23 underlying mutual funds

–  Vanguard uses 3 broad index funds

•  Key factors to consider

–  Fund’s investment style

–  Fund’s historical performance

–  Fund’s fees and expense ratio

http://www.investopedia.com/articles/mutualfund/05/051005.asp

Investment Style Target Date Fund Itself •  Strategic vs. Tactical

– Strategic: Rebalance portfolio to target asset %s – Tactical: Change portfolio in response to current

market conditions Underlying Mutual Funds •  Active vs. Passive

– Active: Use actively managed funds to try to outperform benchmark index

– Passive: use index funds to track a benchmark index

More About Target Date Funds •  Fastest growing asset class used in employer defined

contribution (DC) plans

•  Make up about 20% of DC plan market

•  $670.6 billion in TDF assets in 2014

•  TDF assets could double in size by 2018

•  TDF suppliers include Vanguard, Fidelity, T. Rowe Price, BlackRock, JP Morgan, Principal Financial, and American Funds

http://online.barrons.com/articles/SB50001424053111904544004579651134019266274

Target Date Fund Evolution Process: 1980s-2013

•  1980s: 401(k)s become a supplemental retirement savings plan; 3-legged stool of Social Security, a defined benefit pension, and savings is still intact

•  1990s: Beginning of the “do it yourself” retirement model; more 401(k)s introduced as sole retirement plan and fewer DB pensions

•  2000s: “Do-it-for-Me” model introduced and TDFs gain popularity; defined contribution (DC) plans become primary retirement savings vehicle

Target Date Fund History •  First target date funds created in 1994 by Wells Fargo and

Barclays Global Investors

•  Responded to 401(k) plan participants’ failure to prudently manage their retirement plan portfolios for 10+ years

•  Plan participants wanted someone to make 401(k) investment and asset allocation decisions for them

•  Institutions needed to develop a strategy to use with millions of plan participants

•  Participants were aggregated into age-based cohorts http://www.ucs-edu.net/cms/wp-content/uploads/2014/04/I_ABriefHistoryOfTargetDateFunds.pdf

More Target Date Fund History •  1996: Fidelity Freedom TDFs

•  2001: Principal LifeTime TDFs

•  2002: T. Rowe Price Retirement TDFs

•  2003: Vanguard Target Retirement TDFs

•  2006: Pension Protection Act (2007 for final regs) lead to increased use of TDFs in DC plans

–  Created a “safe harbor” for TDFs as a Qualifying Default Investment Alternative in auto-enrollment DC plans

•  2008: Performance issues raise concerns by SEC and investors, especially for near-term (2010) TDFs

More Target Date Fund History •  2008- TDF investors and regulators became very

aware that “all glide paths are not created equally” •  2009- SEC and Department of Labor hearings on

TDFs; critics claimed TDFs were not as conservatively positioned as their names implied

•  2010- New TDF disclosure rules published by the SEC, including better description of glide paths

•  2013- 36 target date mutual fund firms; 2010 TDFs were only category to “leak” assets (retiring boomers)

•  2015- L fund becomes TSP default option (10/15) http://corporate.morningstar.com/us/documents/MethodologyDocuments/

MethodologyPapers/2014-Target-Date-Series-Research-Paper.pdf

Target Date Fund (TDF) Advantages

•  Provide diversification across asset classes

•  5- or 10-year intervals to meet a variety of needs

•  Generally designed to be a continuing investment for investors during retirement

•  Investors do not have to buy a fund that matches their presumed retirement date (free choice to decide)

•  Can buy for taxable and tax-deferred accounts (if offered as an employer plan option)

More Target Date Fund (TDF) Advantages

•  Fund managers make all asset allocation decisions

•  Many TDFs have low required minimum investments (e.g., $1,000 for Vanguard)

•  Increasingly being offered as default option in tax-deferred employer retirement savings plans

•  Offer a “low maintenance path” for investors who don’t know where to start

•  Like any other mutual fund, subject to Investment Company Act of 1940 regulation (SEC)

Target Date Fund (TDF) Disadvantages

•  Do not address individual risk tolerance levels

•  Do not guarantee sufficient retirement income

•  As with any investment, TDFs can lose money

•  Sometimes (e.g., 2008) all asset classes lose value simultaneously; 2010 funds lost 30% on average

•  Two layers of fees: TDF and underlying funds

•  Can’t make “apples to apples” comparisons

•  Extended glide paths may leave investors exposed to more risk than they want

Other Key Points •  Small differences in fees can translate into large

differences in returns over time

•  Consider a TDF’s asset allocation over the whole life of the fund

•  Consider a TDF’s inflation protection

•  Compare the % of stock at a TDF’s most aggressive and conservative investment mix

•  Consider the number of underlying funds in a TDF

•  Seek out TDFs with expense ratios < 0.84% (industry average)

Future TDF Projections •  Expected to hold 35% of 401(k) assets by 2019

(13.5%) in 2013 according to Cerulli Associates: http://www.wsj.com/articles/fears-about-target-funds-1425870191

•  Vanguard projects that, by 2016, 55% of all plan participants and 80% of new plan participants will be invested entirely in a TDF: http://www.benefitspro.com/2012/06/26/vanguard-managed-retirement-accounts-increasing-in

Target Date Fund Resources •  Investment Company Institute:

http://www.ici.org/pubs/faqs/faqs_target_date

•  U.S. SEC and Department of Labor: http://www.dol.gov/ebsa/pdf/TDFinvestorbulletin.pdf

•  Investopedia: http://www.investopedia.com/terms/t/target-date_fund.asp and http://www.investopedia.com/articles/mutualfund/05/051005.asp

•  U.S. SEC: http://www.sec.gov/investor/alerts/tdf.htm

•  eXtension: http://www.extension.org/pages/63010/monthly-investment-message:-february-2012#.VQyJak0tGM8

Before You Invest in a TDF •  Examine a fund’s fees

•  Review a fund’s past performance

•  Understand a fund’s glide path and stock % landing point; is it a “to” or “through” retirement TDF?

•  Understand a fund’s strategy and its underlying assets; are they active or passive funds?

•  If in a taxable account, know the minimum deposit

•  Read the prospectus!

Key Take-Aways •  TDFs become more conservative automatically

•  Three key performance factors are fees, underlying funds, and glide paths

•  Performance among TDFs can vary dramatically

•  Knowing a TDF’s glide path is critical to understanding its risk profile

•  TDFs work best for your entire retirement savings

–  Many investors combine TDFs with other investments

Key Take-Away Applications •  Decide if the simplicity and automation of TDFs is

attractive to you and/or your clients/students

•  Read a TDF prospectus to understand TDF fees, composition, glide paths

•  Compare the performance of at least three comparable TDFs (e.g., three 2040 funds)

•  Compare the glide path of at least three comparable TDFs (e.g., three 2040 funds)

•  Consider repositioning current, unfocused retirement savings into a TDF

Key Soundbite Investors should know what they are buying because not every target date fund with the same date is the same.

Kevin Laird Kevin Laird joined the staff of the Federal Retirement Thrift Investment Board in November 2007, and currently manages the TSP Training and Agency Liaison team. Kevin is a veteran of the United States Army. He holds a Master of Science degree in family financial planning from the University of Nebraska and a Master of Arts degree in education from Truman State University, and he has earned the Retirement Plans Associate (RPA) designation from the Wharton School of the University of Pennsylvania. He is also a Certified Financial Planner® and a member of the Financial Planning Association and the American Society of Pension Professionals and Actuaries.

INVESTING IN THE TSP

Diversification

• Diversification means spreading money among different investments to reduce risk – AKA “Don’t put all your eggs in one basket”

• “Asset allocation” means spreading (allocating) your investments among different kinds of financial assets to achieve diversification

• Many investors seek to diversify both among asset classes and within asset classes

Source: www.investor.gov

Asset Allocation

Stocks

Bonds

TSP Investment Menu

• Investments for stability – Government Securities Investment (G) Fund – Fixed Income Index Investment (F) Fund

• Investments for long-term growth – Common Stock Index Investment (C) Fund – Small-capitalization Stock Index Investment (S) Fund – International Stock Index Investment (I) Fund

• Diversified investments – Lifecycle Investment (L) Funds

• See tsp.gov/investmentfunds or the TSP leaflet, Fund Information, for more information

Fixed income

(bond)

investments

Equity (stock)

investments

Rebalancing

• “Rebalancing” is bringing your portfolio back to your original asset allocation mix by: – Selling over-weighted asset categories

– Purchasing under-weighted asset categories

• Rebalancing provides a simple way to implement the ”Buy low, sell high” principle, without having to time the market

• Rebalancing reduces the overall risk in a portfolio, discourages emotional decisions and short-term thinking, and enforces the discipline to “buy low – sell high,” BUT . . .

• It doesn’t always guarantee higher returns

Source: http://www.sec.gov/investor/pubs/assetallocation.htm

30

20

6

4

40

30

20

6

4

40

Time Horizon and Reallocation

• The most common reason for changing your asset allocation is a change in your time horizon

• People investing for retirement often reduce their stock holdings and increase their bond holdings as they get closer to retirement age

THE TSP LIFECYCLE FUNDS

Target dates and the “Efficient Frontier”

G 74%

Investment in the L Funds does not protect from investment losses

Expected Risk High Low

Hig

h

Low

Ex

pe

cte

d R

etu

rn

Which L Fund is right for me?

L Income L 2020 L 2030 L 2040 L 2050

Genny b. 1990

Dexter b. 1975

Bobbie b. 1955

How do they work?

• Like their underlying investment funds, the TSP Lifecycle Funds are passively managed – They follow a pre-determined glide path

• Rebalanced – every business day to their target percentages

• Reallocated – every quarter to become more conservative

• Reviewed – annually by professional investment consultants

Reallocation in the L Funds The L2050 Fund Glide Path

July 2010 (inception)

July 2020

July 2030

July 2040

July 2050

(landing)

Tell me more

• TSP investment style is both strategic and passive

• The TSP Lifecycle model combines “to” funds with a “through” fund – Numbered L Funds (e.g., L2050) are dynamic funds that follow a glide

path to their target date

– The L Income Fund is a static fund to last through retirement

• TSP investment funds are similar to, but aren’t literally, mutual funds – No “second layer” of fees

What will I pay?

1 Net cost to TSP participants, averaged across all funds 2 All-in, participant-weighted cost of large 401(k) plans. Source: Deloitte, Inside the Structure of Defined Contribution/401(k) Plan

Fees, 2013 3 Asset-weighted average expense ratio for equity mutual funds. Source: Investment Company Institute, 2014 Investment

Company Factbook

$0.29 per $1,000 1 $4.10 per $1,000 2 $7.40 per $1,000 3

TSP

401(k) Plans

Retail Mutual Funds

(Assumes 7% annual rate of return)

$377,530 (TSP - 0.029%)

$339,206 (401(k) - 0.41%)

$309,075 (Mutual Fund - 0.74%)

50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

Year 1 Year 5 Year 10 Year 15 Year 20 Year 25 Year 30

Pay Less to Invest!!

Why choose an L Fund?

• It’s simple – Make one decision: When will you need your money?

– Each L Fund is actually a diversified portfolio; one fund is all you need

• It’s disciplined and low maintenance – The L Funds are professionally designed and adjust automatically

• It’s cost effective – No additional costs

Questions???

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