After Three Decades, Target Date Funds Are Still Working on Their Track Records

Target date funds are designed to mitigate risks long-term by gradually selling equities and buying bonds, moving from relatively volatile toward more conservative assets as the investor approaches retirement. It is “a form of risk management mostly on the part of the investor, the actual employee in a defined contribution plan,” says Jeff Schwartz, president of risk analytics and modeling specialist Markov Processes International.

Since the COVID pandemic struck in 2020, firms no less prominent than BlackRock, Capital Group and Vanguard have been using derivatives in managing target date portfolios. Futures and options contracts on equities, commodities and currencies are commonly cited in prospectuses.

However, derivatives trades introduce their own unpredictability, other costs and risks: the mismatch between the short-term view taken in derivatives contracts and decades-long assumptions that are baked into target date strategies; and lawsuits from investors who expect actively managed funds to outperform the passive ones that track benchmark indexes.

David O’Meara, head of defined contribution investment strategy at Willis Towers Watson (WTW), is among those who say target date funds have not been a facet of pension plans long enough to prove that they can deliver on projected returns two or three decades down the road. Although these funds have been offered since the early 1990s, they were not embraced by large state and corporate pension funds until the Pension Protection Act of 2006 designated them as qualified default investment alternatives.

“We haven’t had a traditional market cycle,” O’Meara says. “Maybe we won’t have traditional market cycles going forward.”

The Lure of Derivatives

Such concerns could be at least partially alleviated if investors had clarity that derivatives were being deployed for traditional hedging, rather than seeking capital gains.

Jeff Schwartz, Markov Processes Intl.

“You can use derivatives in a classic hedge kind of approach,” says Markov’s Schwartz. “In target date funds, I do think derivatives have the ability to help manage short-term risks and therefore keep employees in the funds and resist the temptation to jump into cash and time the market.”

Target date fund managers are using derivatives because “in the marketplace they're trying to sell their products and stand out” at a time when investing in alternatives has become “fashionable,” Schwartz adds. “They are being utilized more and more, as is a move to incorporate more alternatives.”

“Risk Replacement”

Brandywine Asset Management of Thornton, Pennsylvania, uses a strategy that it calls Risk Replacement in a suite of five target date funds that it started selling to small corporate 401(k) plans in October 2023. It views equity derivatives as more effective than plain vanilla bonds at mitigating the risks of equities.

“Instead of taking money from equities and putting it into fixed income, we directly protect against the downside with put options on the money you have in equities,” explains Brandywine founder and CEO Michael Dever. “Now, if you are hitting retirement in a bear market, you don’t have to worry about whether bonds are also in a bear market.”

In 2022, the S&P 500 fell 18.1% while the S&P Aggregate Bond Index was down 12.03%. The S&P Target Date 2030 Index, which is Brandywine’s benchmark, fell 13.96%. Had it been launched, the Brandywine Target 2030 fund would have lost 11.50%, according to a “hypothetical” in a company report.

 Michael Dever, Brandywine Asset Management

Brandywine expects its use of derivatives to reduce the risk of a 20% drawdown in a bear market by four-tenths of that of the S&P 500 Index. According to Dever, there is an 81% chance of a 20% drawdown over a 10-year period.

From their October 13, 2023, launch to September 22 this year, the five Brandywine target date funds have turned a handsome profit. Brandywine Target 2060, with 93.97% of its portfolio in equities, was up 26.3% during that period. The Brandywine Target Retirement fund, 45.93% of it in fixed income, gained 16.3%.

Currently with $40 million in assets, Brandywine’s target date funds will jump to $90 million with a new allocation by yearend, according to Dever. Rather than owning assets directly, they invest in seven equity funds and two bond funds that, in turn, invest in exchange-traded funds and mutual funds to capture about 85% of their beta exposure, and the remainder with long index futures. Brandywine manages all 14 of its funds through its collective investment trust (CIT).

Prospectus Disclosures

Among other target date managers, BlackRock states in a prospectus for its LifePath Target Date Fund 2045 that “one or more derivatives [are used] to gain exposure to commodities.”

Each of the Vanguard Target Retirement Funds “may invest, to a limited extent, in stock and bond futures,” that prospectus says.

American Funds 2045 Target Date Retirement Fund invests in “derivatives and forwards.” The prospectus cautions, “The use of derivatives involves a variety of risks, which may be different from, or greater than, the risks associated with investing in traditional securities, such as stocks and bonds.”

Apart from how those exposures are disclosed, derivatives positions tend to be short-term, in contrast to target date funds’ lifetime glide paths.

Legal Exposure

Target date funds that use active strategies are arguably incurring greater fiduciary risk regardless of the net-of-fee value proposition, says WTW’s O’Meara. There are lawsuits alleging underperformance in comparison with target date funds that invest in index funds and charge lower management fees.

 David O’Meara, Willis Towers Watson

“An actively managed target date fund will underperform its benchmark at times. That’s a fact,” O’Meara says. “The claim is that the fees are too high for the value being provided.”

BlackRock LifePath Index Funds faced legal tests in federal class-action suits filed by employees against Cisco Systems, Stanley Black & Decker, Wintrust Financial Corp., Capital One Financial Corp. and Booz Allen Hamilton – with judges in each case ruling that underperformance did not constitute a breach of fiduciary duty.

On September 23, Judge John F. Murphy of U.S. District Court for the Eastern District of Pennsylvania issued an order for Vanguard to resolve the claims of investors that they had “unexpected, sizable capital gains tax liabilities” after the company changed the fee schedule for institutional shares in a target date fund from $5 million to $100 million in 2020.

A Quantitative Offset

To cover the cost of options trading, Brandywine uses what it calls a Return Driver Diversifier, which spreads risk across more than 30 investments ranging from equity indexes to bonds, energy, precious metals and agricultural commodities that are not correlated to the target date funds’ benchmark indexes.

Using a modified Black-Scholes model that has been back-tested to 1991, Brandywine buys 4% out-of-the-money put options quarterly and holds them until expiration. If the options expire worthless in a bull market, the Return Driver Diversifier kicks in to defray the cost. To cover positions in fixed income, which is historically less volatile than stocks, Brandywine buys at-the-money put options.

“This will not always work,” CEO Dever concedes. “On average, in two out of 10 years, each of Brandywine’s target date funds will underperform its benchmark.”

It will take at least three solid years of profitable institutional investment in its target date funds for Brandywine to earn the minimal track record required to attract the attention of large pension funds, Dever says. Until then, such innovative strategies are more likely to appeal in Europe, where target date funds that invest in derivatives are increasingly common in CITs for pension plans.

“I am hopeful that [target date funds] become less risky over the years as defined contribution plans grow to be managed more like the institutional management pools that they are – and that they will demand the same investment sophistication that other institutional asset owners demand,” says WTW’s O’Meara.