Creating a Sound Way to Choose TDFs

“Are You in the Wrong Target-Date Fund? Now Is a Good Time to Reevaluate,” by Towers Watson, gives an overview of the growth of TDFs, and touches on guidance from the Department of Labor (DOL) issued in 2013. (See “EBSAOffers Tips for Selecting TDFs.”)

The funds have grown in popularity, notes David O’Meara, a senior investment consultant who specializes in target-date funds at Towers Watson Investment Services Inc., and now require plan sponsors to take more care with choosing the best one for their plans.

In the wake of the Pension Protection Act of 2006 (PPA), O’Meara says, many plan sponsors adopted TDFs in fairly short order. “When they started, there were not a lot of product offerings,” he tells PLANSPONSOR. In fact, he points out that most plan sponsors selected a TDF that was associated with the plan’s recordkeeper, without any particularly rigorous due diligence, because the offerings appeared reasonable and could be implemented fairly quickly. “They saw that [speed] as a benefit to participants,” O’Meara explains.

The offerings now include more sophisticated products and expanded implementation options. Towers Watson points out that the DOL’s guidance provides plan sponsors an opportunity to revisit their exposure relative to plan objectives and participant needs. Active or passive management; custom or off-the-shelf and a process of due diligence are among the issues plan sponsors should think about when choosing a TDF.

O’Meara says a key factor for plan sponsors to consider is the choice between actively and passively managed TDFs. At the time the PPA was passed, there were very few passively managed TDFs, he says, but that has changed: “The marketplace has changed, and there is greater variety within passive off-the-shelf solutions.”

It may still be a small portion of the market, O’Meara says, but the firm has seen more interest in passively managed TDFs in recent years. “We think, at Towers Watson, that active management is a difficult task to accomplish in a single class,” he adds. “You need to be in the top 40% of investment mangers consistently over time to outperform the market. When you look across multiple mandates and multiple asset classes, very few have the skill set across all the classes and mandates to do this.” 

Easy Unbundling

The issue of this kind of ability is specific to TDFs, O’Meara feels, since many skilled managers can outperform in fixed income, for example, or in large-cap U.S. equities. But it is difficult for someone to outperform in each and every class.

These days, plan sponsors can much more easily move to separate or unbundled recordkeeping and investment duties, O’Meara says. “The ability is far greater than it was five, six or seven years ago,” he says. “Large-plan sponsors have a greater ability to use third-party investment mangers or even build custom solutions through further unbundling the components of the recordkeeper, the custody and asset management and portfolio construction.”

A custom approach provides the greatest opportunity for plan sponsors to provide the TDF best suited to their participants’ needs while managing the risks and outcomes specific to the needs of the plan, Towers Watson says. Organizations that cannot pursue custom TDFs (either because of a lack of time or expertise, or a lack of interest in unbundling responsibilities), should consider passive, off-the-shelf products, the paper contends.

A custom approach requires more governance, however, Towers Watson notes. “The DOL has become aware that not every plan sponsor is utilizing their flexibility and strength to negotiate with their vendors to ensure they are getting the best product or at least one they’ve done their due diligence on,” O’Meara says. “In general, we continue to see plan sponsors out there using the funds of their recordkeeper. If you look at the largest recordkeepers, they also happen to be the largest TDF managers.” But custom TDFs maximize fiduciary oversight by putting the oversight of the recordkeeper, custodian and asset manager in one place instead of having separate firms to do it all.

Some sponsors may want to give careful thought to passive implementation in an off-the-shelf product. “One drawback for off-the-shelf providers is that if they don’t have investment skill in a particular class, it probably won’t find its way into the product,” O’Meara says.

Off-the-shelf products simplify fiduciary oversight, O’Meara says. A single manager determines the glide path and typically invests the assets, instead of having separate firms do it all. Plan sponsors will need to choose between active and passively managed funds. Today, O’Meara says, passive funds offer a greater variety of goals and metrics.

Pinning down some of the processes in TDF selection is important. “How much governance are they willing to put into the process?” O’Meara says. If the plan sponsor is squeezed by time or resources, it may be better to separate the responsibility for these decisions, from underlying asset allocation to portfolio construction.

Determining governance capacity is an important task for the plan sponsor, Towers Watson says. That capability allows the plan sponsor to be available for overseeing the selection, implementation and monitoring of the TDF. Limited capacity can steer a plan sponsor toward an off-the-shelf product or to outsource the governance.

A link to download “Are You in the Wrong Target-Date Fund?” is here.