Retirement Investing’s Next Big Phase

Target-date funds may only be step one in the evolution of retirement investing thanks to stricter regulation and technology breakthroughs.

Reviewed by: Cinthia Murphy
Edited by: Cinthia Murphy

Bob Smith, president and CIO of Sage Advisors, a Texas-based ETF strategist, thinks there’s a lot to work on when it comes to helping people invest for retirement. The industry, he says, has done an OK job thus far, but there are a lot of changes taking place at regulatory, advisor and product development levels that should lead to better outcomes for investors everywhere. How will the Department of Labor fiduciary rule—which will be fully implemented by 2018—impact the retirement investing industry?
Bob Smith:
They've identified what the hurdles are in terms of what fiduciary responsibility is, and what the breadth of it is. To a lot of advisors, this is all new, and there are a lot of firms that might not be ready or willing to carry that risk and responsibility.

So you're going to see transference. We've seen it in some of the separately managed account (SMA) fund flows already, where we're getting assets from various large organizations that don't want their advisors taking responsibility. They’re saying, "We're just going to send it to Sage; they're on the platform, and we feel more comfortable with them doing it."

It’s just the beginning. There's still a lot of change to occur. But it's good for firms like us. You have to formalize and declare what you're willing to do as an advisor. We're very strict: We're only going to be a 3(38) fiduciary for what we actually decide ourselves in what we do.

We limit it to our ETF lineup and the selection of ETFs, things we feel we can credibly defend and that we can demonstrate the research and the fiduciary capability to support the process.

Guys who were practitioners, who were dabblers in this industry, are now being forced into the center—are they going to be fiduciaries? You can't go out and be an advisor as you knew it.

But do you want all that responsibility? To declare yourself as a 3(38) fiduciary is not nirvana. It’s the liability that you're going to withstand now with a lawyer. An angry client turns into an angry plaintiff fast. Will ETFs benefit from this DOL rule?

Smith: The key is to keep the process strict, simple and well defined. And ETFs work beautifully in that world, particularly index-based products. You get into more trouble as you get into actively managed ETFs. Not to denigrate them, but they don't necessarily play well in this kind of restricted, very narrowly defined fiduciary liability space. If a portfolio manager makes a bullheaded decision and loses 25% of the fund because he was leveraging the wrong way—how do you defend that? It's going to favor the passive products.

I also think fundamentally driven firms will fare better. We're very conservative in our decision process. We work with proven product. We work with the big providers, not the marginal guys. We're not an algo shop.

If you're building-block-oriented, so to say, basic equities, basic fixed income, or guys who are whipping it around from a tactical standpoint, as good as their numbers are, if it can't be explained to the client when you're out of the room, you're probably going to have a problem somewhere down the road. You don't want to go down the path of having too exotic a lineup of ETFs, in my view, in a 3(38) fiduciary construct. You've got to be really careful about that. To many people, retirement investing equals 401(k)s. Today 401(k)s are dominated by target-date funds. Are they a good solution for the average investor, even in a strict fiduciary setting? Are they tactical enough?

Smith: We have target-date funds, and they're all ETFs; they've been ETFs from the get-go. They were initially custom designed for one particular large client who has a conservative construct. But the question always is, do you have a conservatively designed or aggressively designed fund? Are you tactical or are you more strategic? How do you define that?

There are massive differences from one fund to the other. This is what people don't spend time looking into, because they think they're buying plain vanilla. You're actually buying vanilla ice cream, but it's got tutti-frutti in it; this one's got sprinkles on it; this one comes with chips; this one's got cookie dough in it. It's basic vanilla, but there's a whole bunch of other flavors in there and you have to understand them. I don't think people do that well enough.

Secondly, the reason target-date funds have done so well is the ongoing decline, the inexorable eradication of defined benefit plans. The basic nature of a defined benefit plan—which covered at one point 60% of the workforce in America—was the idea of this protective paternalism that was provided through fiduciary protection, oversight and overlording. The fact is, you were going to end up with a check.

When that started to decline—and the Pension Protection Act was kerosene to that whole process because it became very costly to sustain it with unreal discount rates and earnings assumptions—the unintended consequence was the eradication of the defined benefit plan by the private sector. You take away all that paternalism, and what are you left with? The defined contribution plan.

You see what happens in DC plans. In the absence of target-date funds, all we heard about was how badly investors were doing left to their own devices, and that education wasn't working. In comes the target-date fund. It fills the paternalism vacuum. It takes them back to the days of yore, of the set-it-and-forget-it.

Target-date funds were a good stopgap, but this is not where DC plans are going to end up, because of technology and the ability to communicate broadly with huge workforces online. People are more used to doing this now. They shop online every day. They can invest online every day. It's not a unique experience anymore; it's like a utility.

The utility and communication abilities have now allowed technology to step into the breach here and say, we can make funds more customized. Let's see if we can't get your target-date fund to speak a little bit more effectively to you; or in fact, let's not even do a target-date fund. Let's design your own fund that has its own targets. That's where we're headed.

Even the big providers of target dates will tell you this. In the quiet moment, they'll admit this is not the last stop. This is going to keep evolving. We're going to customization, taking on a broader array of alternative asset classes, which are now deliverable through ETFs. I recently talked to Martha King of Vanguard and she had a strong argument about ETFs not fitting well in a 401(k) plan. You clearly disagree.

Smith: Totally. Just look at what's going on in the robo community, because I think the next iteration of what's going on here is you're going to do robo DCs. It's coming. Betterment tells you that. They've got 150 plans in the last 18 months. They don't have any marketers. There are people throwing themselves at them: "Oh, this is so much easier and better, thank you very much." Human resource guys: "I'm so tired of this. Take it off my hands."

What kills the effectiveness of 401(k) plans is a number of different things. One is paradox of choice. I've got too many funds, I don't know what to do; I'm just going to leave it in cash. That's the first thing.

Second thing is, it doesn't speak to the individual; it speaks to the group. It doesn't speak effectively to how an individual wants to invest, and the technology that's being brought to fore right now does that.

From a DC standpoint, you can address the paradox of choice. You can address the communication skills set. You can address the customization. You can address the affordability issue in terms of that the cheapest fee is not the best fee.

There are lawsuits saying, “Look, you selected Vanguard and I'm going to sue you for that, because your rationale was that it’s the cheapest thing, so it was good. But it underperformed all these other peers. I would have easily paid up another 10 basis points and gotten 100 basis points better return. So did you really give me the best choice?”

I understand what Vanguard's talking about, but they're talking out of both sides of their mouths, because when you sit down and do a Betterment solution, 90% of the answers spit out at you all happen to be Vanguard ETFs. So, seriously? California passed legislation that’s broadening access to 401(k)s. That’s an issue: lack of access. Who serves the lower-income population, accounts of, say, $5,000 or less? Are robos the only retirement investing solution for them?

Smith: Here's a company you want to look at: Honest Dollars. That's their whole marketplace. They want the bartender, the waiter, the cab driver, the independent home cleaner. They want everybody who's out there who is forgotten, and who doesn't have an IRA. They can set you up in 90 seconds, and give you the ability to start investing. If you want to know where the world is going—and I'm not saying it's going to be successful—look at companies like this.

If states want to go to these broadly diversified plans, they need to be able to do this in a very connected way. They can't bring a bunch of different providers to divide up the state of California. It has to be like a 529 plan, with a similar structure. And we can design a similar structure with a robo that can work statewide, in a kind of state-sponsored, state-driven investment experience. This is where the technology blossoms.

So, again, that's why I'm saying there's a lot of revolution and evolution going on in the retirement investing space. What happens when the accumulation of wealth phase ends, and the investors begin to spend their retirement money. Who helps the investor then? Is there any sort of industrywide responsibility somewhere in this phase?

Smith: No. You're basically left at 30,000 feet. The guy parachutes out, saying, “OK, now you gotta land it.” The investor says, “I don't know how to fly this thing.” There’s a big transition problem. Transition management has a number of different issues associated with it. Deaccumulation, what does that mean? Well, my spending plan. So what's my burn rate? Is it 4%, 3%?

The second aspect is, how long are you going to live? How many maladies are going to come your way, because cancer, heart attack and strokes are all diseases of aging. How many upsets do you think you're going to go through, and how well prepared are you for that? Again, brokers want to be talking about growing a business, not keeping a dying business going.

The third thing is, off of longevity risk and off the spending rate, is the tax issue. Let's say you’re 65 years old and you’re going to live for another 20 years. But everything you earn now—because it's not in a pension plan and it's not Social Security—is now taxed by Uncle Sam if you’re outside the IRA. So, what's optimal on a tax-adjusted basis is really different than on a gross basis. And most of the world in terms of figuring out solutions is all done gross, not net. When you look at the world in terms of, “I want to get this dollar amount, but now for the next 20 years, I'm going to be saddled with a 25% tax rate on everything I earn,” what does that do in terms of the risk I need to take, the asset allocation?

Not many people have thought about that yet. Uncle Sam's not going to let up, because the entitlement barrage that's coming is massive. There's no way they're going to sit there and say, "We can't raise taxes." They're going to. So that's why I say there's a lot of different parts in here that have to be talked about that are problematic, because they don't fit well in the preretirement-gross-of-taxes world of optimization. Is there anything the investor can do to protect themselves?

Smith: Get themselves aligned with people who can provide that kind of information, or those kinds of support services. This is where wealth management will live. But there's not a lot of people who can afford to have a trust and estate lawyer. There's not a lot of people who have their own CPAs and their own CFP at $150 an hour working out what they should do.

Is there a cheaper, better way to address that? I go back to the world of robos. We're shifting from digital transaction, which is where robos were, to digital advice. I don't know that we'll get to digital trust and estate. I don't think we should. But we can certainly pick portions of that and have portions of tax sensitivity in the digital advice space.

There has to be more behavioral effort put into the design of these things to anticipate how people react, to coax them out of their shells to give better answers so that you can have a better process. I think that's where we're going. And I think the success of this is not going to come from Silicon Valley; the success of this is taking Silicon Valley thinking and technology being driven from the asset management side. And that's where ETFs come into play. They’re a natural fit with the technology.

Contact Cinthia Murphy at [email protected]


Cinthia Murphy is head of digital experience, advocating for the user in all that does. She previously served as managing editor and writer for, specializing in ETF content and multimedia. Cinthia’s experience includes time at Dow Jones and former BridgeNews, covering commodity futures markets in Chicago and Brazil equities in Sao Paulo. She has a bachelor’s degree in journalism from the University of Missouri-Columbia.