2022 was rough year for near-retirees in target-date funds

Last year was a difficult one for mutual funds and ETFs generally, but a category of all-in-one products that serve as the backbone of 401(k)s — target-date funds — offered almost no shelter for people on the cusp of retirement.

Among open-end U.S. target-date funds, those with a 2025 vintage saw median total returns of -15.4%, slightly higher than the median of -18.3% for 2055 funds, according to data from Morningstar Direct. Looking at average asset-weighted returns paints only a slightly better picture, at -14.3% for 2025 funds and -16.8% for 2055 funds.

“If you look at 2022, there wasn’t much that would protect them, because stocks and bonds lost double digits,” said Megan Pacholok, senior manager research analyst at Morningstar.

Treasury Inflation-Protected Securities, or TIPS, didn’t seem to provide much help, she noted. One asset class, commodities, was an exception, although it makes up only a small proportion of overall target-date fund allocations, largely because it had fared poorly over the past decade, Pacholok said. “2022 was a bit of a one-off.”

After the 2008 financial crisis, target-date funds received a lot of criticism because many near-retirees lost about a third of their savings in those products. Following that, some fund providers reconsidered the glide paths they use, in some cases slightly lowering the stock allocations near the fund's target date. However, that short trend faded, and it's now common to have 50% or more of assets in stocks. The idea behind higher equity allocations is that retirement spans decades, and target-date investors often need significant return potential early in their retirement years to help make their assets last.

Regardless, target-date funds with 2025 vintages that had lower equity allocations still saw double-digit negative returns last year, according to the Morningstar report published Tuesday. For example, the John Hancock Preservation Blend Portfolio, with an average equity allocation of 20.2%, had a negative return for 2022 of -12.7%. The Dimensional Target Date Retirement Income Fund, at 31% equity, lost -20.1% during the year.

Meanwhile, the T. Rowe Price Retirement Fund, at 56.3% equity last year, returned -15.5%, and the American Funds Target Date Retirement Fund, with 49.6% equity, returned -12.7%, according to Morningstar’s report.

Fund companies don't seem to have adjusted their products in response to the rough market last year.

“They didn’t withdraw their playbook,” said Pacholok, who is one of the authors of the new report. “They were staying with their approach, which makes sense, because a target-date fund is a long-term [investment].”

Someone who has long pointed to the risk of target-date funds, Ron Surz, said that although the products have not had to worry about sequence-of-returns risk for the past 13 years, 2022 gave a taste of the dangers that could lie ahead.

“Target-date funds are not safe for people near retirement," he said, noting that the vehicles are “85% risky” in the five years before and after retirement, reflecting their average allocations to stocks and bonds.

Surz, whose firm Target Date Solutions has patented a glide path for the products, said that target-date funds should be “70% safe” near retirement, meaning that that proportion of money should be in an asset-preservation option.

“The Federal Thrift Savings Plan is probably the poster child for safety,” he said, pointing to the 70% allocation that near-retirees have in the government-backed fund.

However, “what matters most is not your rate of return, but your contributions,” Surz said. “Your rates of return really don’t matter until you’re about to leave the workforce. At that point it matters a lot … There are no more paychecks.”

CITS UP, COSTS DOWN

A big trend among target dates is a shift away from mutual funds and toward collective investment trusts, or CITs, which tend to cost less but don't have the same transparency requirements as 40 Act mutual funds.

Last year, about $56 billion in assets were transferred from target-date mutual funds to CITs with identical or nearly identical strategies, according to data self-reported by asset managers to Morningstar, Pacholok said.

CITs have grown in popularity as their investment minimums have gone down, and providers are offering them to smaller retirement plans. CITs now account for 47% of the U.S. target-date market by assets, and they will likely match or surpass mutual funds by the end of 2023, she said.

“At the end of 2023, it will be a photo finish in terms of whether they are able to overtake mutual funds, but it’s definitely something that will happen within the next couple of years,” Pacholok said.

Last year, more than $153 billion of net money flowed into target-date products, but total assets in them declined from $3.27 trillion to $2.82 trillion as a result of market performance, according to the report. Of the net inflows, $121 billion went to CITs, while $32.3 billion went to mutual funds.

During the year, the average asset-weighted expense ratio for target-date funds dropped 2 basis points, going from 34 bps to 32 bps. By comparison, that figure was 60 bps in 2013, according to the report. Some target-date mutual fund series with significant cost reductions last year were Vanguard’s Target Retirement (11 bps to 8 bps), Voya Index Solution (57 bps to 46 bps), Allspring Dynamic Target (68 bps to 60 bps), Fidelity Freedom Blend (60 bps to 55 bps) and the Natixis Sustainable Future series (58 bps to 53 bps).

The biggest player in the market, Vanguard, saw its share of target-date assets increase from 36.4% in 2021 to 37.5% in 2022. Fidelity’s share increased from 13.9% to 14.2%, and T. Rowe Price’s was nearly flat, going from 11.5% to 11.4, according to Morningstar.

Meanwhile, BlackRock, the fourth-largest provider, saw its share slip, from 9.5% in 2021 to 8.8% last year.