David C. Brown: The Underperformance of Target Date Funds | Rational Reminder 374

Episode Overview

• This episode features Professor David C. Brown discussing his extensive research into the performance and characteristics of Target-Date Funds (TDFs), the default retirement investment for most Americans.
• It reveals that TDFs are difficult to benchmark due to varying glide paths, but a custom replicating benchmark shows they underperform, on average, by about 1% per year due to fees and poor active management.
• The conversation highlights the massive and often-overlooked dispersion in returns between different TDFs, even those with the same target retirement date.
• The discussion also analyzes TDF management strategies, finding that tactical deviations from the strategic glide path tend to harm investor returns, emphasizing the need for greater transparency for plan sponsors.

Key Concepts

• Target-Date Funds (TDFs): TDFs are "one-stop-shop" retirement funds that automatically de-risk as an investor approaches retirement. They are the most common default investment in US 401(k) plans, capturing over 70% of new contributions.
• The Benchmarking Challenge: Comparing TDFs is complex because each fund family has a unique glide path and underlying holdings. Professor Brown's research solves this by creating a custom, passive replicating benchmark for each TDF based on its stated asset allocation.
• Performance Drag: On average, TDFs underperform their passive replicating benchmarks by approximately 1% annually. This underperformance is attributed to high fees (around 55 basis points) and poor active management of underlying funds (around 45 basis points).
• Dispersion in Outcomes: There is a massive performance difference between the best and worst TDFs. Research found a 23% difference in monthly returns between the top and bottom performers within the same target date vintage in one instance.
• Plan Sponsor Responsibility: Individual investors typically cannot choose their TDF provider within a 401(k); this decision is made by the plan sponsor (e.g., their employer's HR department). The research aims to equip these sponsors with better data to make informed choices.
• Tactical vs. Strategic Glide Paths: The research distinguishes between a TDF's long-term strategic glide path and short-term tactical changes. It finds that managers who make frequent tactical changes tend to underperform those who stick to their strategic plan, costing investors about 10 basis points per year.

Quotes

• At 1:19 - "On a monthly basis as people are contributing, over 70% of the money is going into target-date funds now." - Professor David Brown on the massive and growing significance of TDFs in US retirement accounts.
• At 3:12 - "It was about 1% per year is how much they underperform these replicating fund benchmarks." - Professor David Brown summarizing the key finding on the average performance drag of TDFs.
• At 4:21 - "There was one month in which if you compared TDFs within a given vintage, the difference in the monthly return between the best and worst performers was 23%." - Professor David Brown highlighting the extreme dispersion in outcomes that can exist between different TDFs with the same target date.
• At 37:11 - "When fund managers are active, they are doing so... to the detriment of investors." - Summarizing the key finding that tactical glide path changes, on average, have historically hurt investor returns.
• At 44:59 - "My co-author and I want to get our data out there that way people can make better, more informed decisions." - Stating the ultimate goal of his research is to empower plan sponsors and investors with transparent data.

Takeaways

• Target-Date Funds are not a commodity; there are enormous differences in fees, strategy, and performance that can significantly impact retirement outcomes.
• On average, TDFs underperform a simple passive version of their own strategy by about 1% per year, eroding long-term returns.
• Active management within TDFs, whether through underlying fund selection or tactical glide path changes, has historically hurt performance more than it has helped.
• Plan sponsors hold the key to improving outcomes, as they are responsible for selecting the TDF family offered to employees, making transparent benchmarking data crucial.