Benchmarking Custom TDFs Is Not an Exact Science

However, there are methods to create a benchmark, and consultants and investment managers should be able to help.

Benchmarking custom target-date funds (TDFs) is complicated and not an exact science, retirement plan experts say. They add that the additional administrative cost of conducting this type of benchmark has convinced many large plans to select off-the-shelf products rather than create custom ones.

Sue Walton, senior retirement strategist at Capital Group, says that prior to joining the investment firm, she was a consultant to mega plans, many of which asked her to explore custom versus off-the-shelf TDFs.

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“With custom solutions, it is quite challenging to find appropriate benchmarks, as opposed to a fund that is singularly focused on large-cap, growth or value,” Walton says. “However, there are index benchmarks available in the marketplace, such as the S&P 500 for large-cap, the Russell 2000 for small-cap and the MSCI ACWI ex-USA Index for emerging markets.”

If the plan positions the percentage of the benchmark of these indexes relative to the glide path of the underlying funds, it can create a multi-benchmark for a custom TDF, Walton explains. “It is not a perfect solution in that it cannot show you how the fund is performing relative to peers of off-the-shelf solutions, but it is an approximation that you can create. The benchmark would have to be recalibrated for each year of the vintage as the glide path changes. In that sense, it would be a dynamic benchmark. The adviser and the sponsor would have to rely on the asset managers of those strategies to provide this custom benchmark.”

It is precisely because of this complicated benchmarking process, Walton says, that “we have seen a number of large plan sponsors with custom strategies move away from those to off-the-shelf solutions.

“Even if the TDF selects best-in-class funds for each of the objectives of its glide path, funds don’t always play well together and complement each other,” she continues. “Further, sponsors and participants may not necessarily realize the benefits of the additional costs, particularly the administrative cost and the cost of education, of the custom solution. This sets a high bar for the custom solution to be able to add value, net of all of the administrative costs. This is not to say that custom solutions don’t work—it is just important for sponsors and advisers to be aware of their complexities.”

Jake Gilliam, head of multi-asset solutions at Charles Schwab, says that when plan sponsors are determining the benchmark for a custom TDF, it is important to understand “the unique problem that the sponsor is trying to solve by turning to a custom solution.

“That is the first and foremost point that should be addressed when determining how to benchmark the custom TDF,” he says. “The sponsor needs to ask itself how the fund and all the related education meet that need, and whether participants are using the strategy as intended. They can then explore how the fund is performing relative to other solutions that are off the shelf and ask the all-important question: ‘Is the custom solution adding value?’”

Gilliam also says he’s seen many large sponsors move away from custom solutions. “In general, the focus of the past several years has been on cost and complexity, and keeping cost as low as possible in step with limited complexity, which is why we have seen more interest among large plan sponsors in off-the-shelf solutions.”

However, David O’Meara, a senior investment consultant who specializes in TDFs at Willis Towers Watson, maintains that any expert retirement plan consultant or large investment manager should have a reporting system capable of matching multiple benchmarks against the glide path of a custom or an off-the-shelf TDF. “With the right tools and reporting system—one that houses all of the returns of all of the available indexes—it is fairly straightforward to put together. All you need to do is simply match up the target-date allocations with those indexes and roll them up at an aggregate level. For all the major consulting firms and investment managers, reporting this benchmark back to their clients should be a relatively straightforward process.”