Russell Investments published a short white paper looking at key questions that can help plan sponsors make sure their target-date funds (TDFs) remain on course and serve participants’ best interest.
In the article, Josh Cohen, managing director of defined contribution, and Rod Greenshields, consulting director, argue that TDFs have become so popular because they don’t require much ongoing input from participants. However, the funds do need to be regularly updated by providers, Russell says, and sponsors have an ongoing fiduciary duty to make sure the products gel with participant needs. Otherwise, TDF models can drift out of touch with participant behavior or prevailing market conditions.
Some factors for sponsors and plan fiduciaries to monitor include the impact of current market conditions on TDF model assumptions; whether TDFs are well-matched to real participants’ age demographics; the possible mismatch of income replacement goals and TDF model expectations; potentially unrealistic salary growth assumptions; and shifting regulatory requirements. These factors can impact the performance of a TDF over time, Russell says.
The research led to some modest changes to Russell’s glide path, John Greves, TDF portfolio manager for Russell, tells PLANSPONSOR. Perhaps the most significant change was that early stage equity allocations have increased slightly to reflect lengthening lifespans and the rising costs of health care in retirement.
According to Greves, adding or subtracting just a few years in retirement age can make a big difference in retirement income needs—and therefore in retirement readiness. Every year of delaying retirement provides a twofold benefit by giving people one more year of savings opportunity, plus one less year of spending. In addition, Russell notes that delaying the need to claim Social Security can significantly increase the size of their monthly check.
At the same time, the actual retirement date can be a risky stage in an investor’s financial life, Greves says. From this point in time, new retirees must fund their retirement for the longest period, yet their influx of regular contributions will cease. For all these reasons, keeping a close eye on participant age demographics and how a TDF series addresses the numerous near-retirement risks faced by TDF users are key to satisfactory performance and fiduciary protection for sponsors.
Another issue is that many TDFs don’t identify an income goal, Greves notes. Now that DC plans are the predominant retirement plan for most American workers, the mindset of both plan sponsors and participants must shift toward a focus on retirement income goals, he says. Guidance can help participants define reasonable retirement spending based on salary levels, the contributions that they and their employers make, and the time horizon available to them.
Greves says Russell’s most recent TDF glide path adjustment used detailed income-needs research on retiree prescription drugs and long-term care expenses. The target replacement income was increased six percentage points to provide a cushion for such costs.
Another key question Russell urges sponsors to ask is, “How do the assumed contribution rates [underlying the TDF series model] compare to actual contribution rates?”
Employee behavior, employer matches and employer non-matching contributions all need to be taken into account when determining true contribution ability, Cohen and Greenshields write.
“For example, we took a close look at various matching structures when evaluating our glide path assumptions at Russell,” the pair explains. “Currently, the most common match structure in 401(k) plans is for the employer to match 50% of employee contributions up to 6% of employee earnings. Half of plan sponsors also make non-matching contributions at an average rate of 5% to 6% of earnings. Based on these findings, we raised our model’s contribution estimate to 9% early in a career and assume a gentle acceleration each year thereafter.”
This gets to another important challenge in analyzing and monitoring TDFs: Are the salary and salary growth assumptions realistic?
Greves explains that Russell recently updated its assumptions for the pattern of the total lifetime contributions of the average DC plan participant. He says salary assumptions need to account for some complex variations over the course of a career. For example, wages tend to be lower during the early years but grow more rapidly; they can be higher in later years, but the growth slows. Earnings growth may even be negative in real terms as participants approach retirement. A TDF glide path should be sophisticated enough to address these points.
Greves also points out that Russell’s strategic, long-term return assumptions for both equity and fixed-income asset classes have decreased materially from when the firm designed its first TDF glide path.
“Asset allocations embedded in today’s glide path must account for performance assumptions,” say Cohen and Greenshields. “Participants may need to take on more risk in order to have a realistic chance at a sufficient real return, and they may need to increase contributions to make up for lower returns.”
Cohen and Greenshields suggest that, for those already in retirement, low interest rates have pushed up annuity prices and long-term care premiums, while pushing down the amount of money retirees can withdraw each year. In response to this environment, Russell has modestly increased the allocation to growth assets in its glide path as part of an effort to improve participant outcomes, they explain. In the short term, markets fluctuate around projected long-term trend lines, so Russell believes portfolios also should be managed dynamically to improve the chance of reaching the desired outcome.
Finally, sponsors must ask whether asset allocations meet shifting regulatory requirements. As Russell explains, plan sponsors can designate an investment option as a default, which will prescribe an asset-allocation solution when participants make no other selection. To be designated as a qualified default investment alternative (QDIA), a TDF must fulfill multiple requirements, including having a mix of growth and capital preservation assets in all vintage year funds.
“Many in our industry default toward 90% growth and 10% capital preservation assets for younger participants,” Cohen and Greenshields write, “but we believe this allocation should be reconsidered as market conditions change. Russell has changed its TDF allocation to 93% growth and 7% capital preservation assets. This recognizes market conditions that have existed over the past few years, but is still designed to comply with Department of Labor regulations.”
The full Russell analysis is available here.