Since target date funds (TDFs) were designated a Qualified Default Investment Alternative (QDIA) in the Pension Protection Act of 2006, their role in defined contribution plan line-ups has been super-sized. At the close of 2014, total TDF assets (including mutual funds and collective trusts) exceeded $1 trillion. According to Vanguard’s How America Saves 2015 report, TDFs are now offered in 88% of DC plans on the firm’s platform. Among plans that have designated a QDIA, 90% chose TDFs. TDFs account for an average of 23% of total plan assets, and 41% of new participant contributions are being allocated to TDFs. With the use of automatic features (such as auto-enroll) increasing among plan sponsors, the percentage of plan assets allocated to TDFs is expected to continue to grow.
Until a few years ago, the biggest question facing plan sponsors regarding TDFs was “should the plan offer TDFs?” In most cases, if the answer was yes, the plan sponsor would add the TDFs offered by its recordkeeper to the investment menu. Non-proprietary TDFs (those not offered by the recordkeeping firm) were rarely made available. In recent years, however, the landscape has changed. While not always the case, today plan sponsors are generally able to select TDFs that are not the proprietary product of their recordkeeper. Recordkeeping firms that allow plans to offer non-proprietary investment products are said to be “open architecture.”
Open architecture has translated into a greater choice among TDF products. While having choices is a good thing, the number of TDFs on the market, the differences between various TDFs, and the complexity of TDFs (as they are asset allocation vehicles with layers of underlying parts) make that choice a difficult one.
One of the most significant ways in which TDFs differ is in their varying levels of exposure to higher-risk, higher-return assets classes (what PEI considers “growth-seeking” assets). The allocation to growth-seeking assets is also a key driver of a TDF’s performance and volatility profile. In addition to domestic and international equities, PEI considers emerging markets fixed income, high yield fixed income, real estate and commodities to be growth-seeking assets. In PEI’s proprietary TDF database, which consists of over 30 of the largest TDF providers, the range in exposure to growth-seeking assets is wide.
At retirement, for example, the exposure to riskier assets ranges from 25% to 72% of assets. The market decline in 2008-2009 brought these differences into glaring focus as funds with higher exposure to growth-seeking assets suffered much steeper declines than those funds with less exposure.
The hefty amount of assets going into TDFs and their use as a plan’s default investment option have made it very important for plan fiduciaries to understand the inner workings of these complex products and to select one that is appropriate for their participants. The Department of Labor (DOL) agrees. The growing number of TDF products available to plan sponsors, and the significant differences in their composition and risk/return profiles, has prompted the Department of Labor to focus on the products. The DOL’s Employee Benefits Security Administration is in the process of developing a new set of guidelines for TDF disclosures to investors. Furthermore, the DOL issued a set of best practices for TDF evaluation in February 2013, titled “Target Date Retirement Funds – Tips for ERISA Plan Fiduciaries.”
Outline of a Prudent Process
PEI believes it is imperative that plan fiduciaries establish and follow a prudent and robust process for the evaluation and selection of the TDF product it offers to its participants. While such a process should incorporate all of the best practices outlined by the DOL, a prudent process should also include a discussion of the tradeoffs associated with the key components of TDFs. As such, PEI suggests that plan fiduciaries engage in a two-step process as they evaluate and select the TDFs offered to participants:
- An overview of the TDF landscape to help plan sponsors understand the tradeoffs associated with key components of TDFs: glide path design, utilization of active and/or passive (indexed) underlying funds, asset class diversification and cost. The goal of the first step is to help plan sponsors identify key preferences for a target date fund provider.
- An analysis and comparison of several TDF products that share the preferred criteria identified in the first step. The goal of the second step is to either confirm the suitability of the plan’s current provider or to select a new provider that best meets the established criteria.
STEP ONE: TDF Overview and Analysis of Tradeoffs
First, an understanding of the plan sponsor’s objectives for using a TDF needs to be established. Through a robust discussion of how and why TDFs are constructed, and the various tradeoffs associated with the various components of a TDF, the plan fiduciaries will have a better understanding of the type of TDF that will provide the best fit for their participants.
Understanding the glide path – the exposure to risky assets and how that exposure is reduced over time – is paramount to TDF evaluation and selection, as it is the primary driver behind the participant’s experience and outcome (in terms of both returns and volatility of those returns). In constructing the glide path, a TDF provider is primarily focused on managing two main sources of risk faced by investors as they plan for retirement: volatility risk (also known as shortfall risk or market risk) and longevity risk. TDFs that are more focused on mitigating longevity risk tend to have higher levels of exposure to growth-seeking assets along the glide path. Those that are more focused on curbing volatility risk tend to have lower exposures to growth seeking assets.
The slope of the glide path is also important to evaluate, as the pace at which the TDF becomes more conservatively invested introduces an additional risk. As participants approach retirement, the impact of a period of negative returns is more pronounced, as there is less time to recoup losses before withdrawals from the account begin (presumably at retirement). A steeply sloped glide path – one that de-risks over a shorter time frame – introduces the risk that in a declining market, assets may be sold as part of the de-risking process when their values are depressed, thus locking in losses.
An analysis of various glide paths, with differing levels of focus on longevity risk and volatility risk, and an understanding of the tradeoffs associated with different glide paths, can help plan fiduciaries identify the type of glide path they feel would be most
suitable for their participants.
Another factor possibly influencing the identification of glide path preferences is plan-specific demographics. The participant base of most plans is typically diverse, so that analyzing average plan participant data is not particularly meaningful. There are, however, circumstances in which certain plan characteristics can make the plan somewhat of an outlier and can impact the glide path decision. Participant demographic data that may influence plan fiduciaries as they identify glide path preferences include: participants’ average age of retirement, availability and participation in a defined benefit plan, participant investment in company stock within the plan, and what participants do with their account balances at retirement. Should a plan’s participant base be meaningfully different from most plans in any of these ways, plan fiduciaries may be inclined to prefer a glide path that is either more conservative or more
Active vs. Passive
TDF providers vary in how they gain exposure to different asset classes. Providers may use passively managed (indexed) strategies, actively managed investment strategies, or a combination of both. There are benefits and drawbacks to each approach, with tradeoffs including cost, asset class diversification, potential to add value above an index, flexibility and simplicity. A growing number of TDF products incorporate both actively managed and indexed strategies, as a means of balancing various tradeoffs.
STEP TWO: Selecting (or confirming) a TDF provider
After the first step in the process is complete, the plan sponsor will have a better sense of the TDF characteristics that would be most suitable for the plan and will be able to identify several key TDF preferences. PEI believes that as a second step, plan fiduciaries should analyze and compare several TDF providers that exhibit the key preferences identified in step one. The analysis should include both quantitative measures and qualitative considerations, and should be presented in a format designed to easily highlight the characteristics that differentiate the TDF products.
Investment philosophy and TDF objective
Plan fiduciaries should have an understanding, at a high level, of the goals and objectives of each TDF provider. For example, goals and objectives may include: reducing market volatility as participants approach retirement or minimizing the risk of outliving retirement assets. In addition, some TDF providers have specific income replacement objectives.
Glide path comparison
Plan fiduciaries should evaluate each TDF’s exposure to growth-seeking assets along the glide path. Not only does this provide insight into the exposure to more volatile asset classes over time, but it also shows the pace at which each provider reduces risk over time. The glide path analysis should include an evaluation of the TDF providers’ exposure to risky assets in the years preceding retirement and in the years after retirement and should show the point at which each glide paths reaches a “landing point” – the point at which the de-risking process is complete and the asset mix remains steady. The glide path analysis should also include a depiction of the range of exposures of the entire TDF peer group, so that plan fiduciaries can also compare each glide path to the broader TDF peer group.
Asset class diversification
Plan fiduciaries should consider the level of asset class diversification in each TDF product, as this varies widely between providers. Some TDFs use as few as five underlying funds, reflecting their focus on keeping both costs and level of complexity low. Other TDFs are invested in a much broader array of asset classes and underlying strategies, reflecting the providers’ conviction in the benefits of diversification.
For each TDF product being evaluated, an analysis of the underlying strategies should be conducted. This will provide insight into the allocation to sub-asset classes (international small cap stocks, for example) and investment styles. The analysis should include, at a minimum, assets in each underlying strategy (to highlight both fund capacity issues and if the TDFs are being used to seed new strategies offered by the firm) and performance relative to peers and/or benchmarks.
The performance of each TDF relative to custom benchmarks and to TDF peers should be part of the evaluation process. The relevance of performance comparisons between TDF providers is limited, as much of a TDF’s performance can be explained by its glide path and should not be the sole criteria upon which the selection of a TDF provider should be judged. However, looking at TDF performance does offer a framework for discussion. Furthermore, there are drivers of a TDF’s performance in addition to the glide path, including the performance of underlying funds, exposure to different asset classes, and tactical asset allocation decisions.
While the returns earned for participants are important, so is the volatility participants have to withstand to achieve those returns. An analysis of the volatility of returns for each age vintage, as well as risk-adjusted returns of each TDF provider should be evaluated.
Cost and Vehicle
Expenses are an important consideration. Like any investment, the expenses of a TDF directly impact results. Not only is it a fiduciary’s responsibility to evaluate and monitor expenses, but there has also been an increased focus on fees in recent litigation. A complete analysis and comparison of TDF providers in terms of expenses should be conducted. This fee analysis should be customized for each plan, taking into account specific plan characteristics. The fee analysis should include information on all different vehicles (mutual fund, collective trust, or separate account) and/or share classes that would be available and appropriate for the plan. Smaller plans, for example, may need to generate enough revenue through their funds’ expenses to pay for administrative costs. Larger plans, on the other hand, may not need to generate additional revenue and may have access to lower cost vehicles.
The PEI TDF Process
PEI’s process for evaluating and selecting a TDF is a comprehensive one, reflecting the predominant role TDFs play in a defined contribution plan line up. Our two-step process incorporates all of the best practices outlined in the DOL Tips Sheet and offers full documentation that a prudent process has been established and followed. PEI recommends that the full two-step process be conducted regularly, as the TDF landscape continues to evolve, individual TDF products change over time, and plan demographics may shift. While outside the scope of this paper, in addition to the two-step evaluation and selection process, PEI recommends following and documenting a regular and robust process for monitoring the TDFs offered in a plan line up.