Improving Participant Outcomes With Custom TDFs

Off-the-shelf TDFs may not meet the needs of participant demographics, so plan sponsors can build custom TDFs to provide greater diversification and less risk near retirement.

Susan Czochara, practice lead, Retirement Solutions, at Northern Trust Asset Management (NTAM) in Chicago, says when she thinks about how defined contribution (DC) plans have evolved, one of the big things that sticks out to her is that target-date funds (TDFs) have done a good job of moving participants in a better direction with a broader asset allocation.

As the evolution of TDFs continues, Czochara says there are two reasons why a plan sponsor would choose to create a custom TDF. One is implementation; if they use certain managers for their core investment lineup, they may want to use those managers for their TDF as well.

The other reason to create a custom TDF is if a plan sponsor is not finding a glide path in off-the-shelf products that they feel meets the needs of their participant demographic, Czochara says, adding that this could be the case if, for example, participants generally retire at an earlier age or if they retire at a later age. Another example may be that some participants have access to a defined benefit (DB) plan and others do not.

Mike Swann, client portfolio manager at SEI Institutional Group in Oaks, Pennsylvania, says there are very few plan sponsors with a participant base that is completely average, which is what off-the-shelf TDFs cater to—the average participant. He points out that the Department of Labor (DOL) has said it is worth considering whether a custom TDF would be appropriate.

“We’ve found the diversification of off-the-shelf TDFs varies widely by provider,” says Jake Tshudy, managing director at SEI Institutional Group in Oaks, Pennsylvania. “Many have a heavy concentration in equities, putting participants at risk, especially near retirement.”

Swann says whether an off-the shelf target-date fund series is diversified enough depends on how it approaches the investment market. For example, if the series uses only passively managed funds, it might not have some asset classes included. He says very few are diversified by asset class or by investment managers.

When building a custom TDF series, plan sponsors can look at best investment practices for defined benefit plans, Swann says. They can use asset classes not included in off-the-shelf products and diversify active and passive funds by asset class as well as investment managers by asset class.

DB plans have used private equity investments for years to smooth out volatility in returns. Recently, the DOL issued an Information Letter that essentially approves the use of “a professionally managed asset allocation fund with a private equity component as a designated investment alternative for an Employee Retirement Income Security Act (ERISA) covered individual account plan.”

“Education about private equity is needed due to the pricing, benchmark, liquidity and disclosure issues. We don’t see private equity making its way quickly into TDFs,” Swann says.

Custom TDFs are well-suited for private equity investments, Tshudy says, but he notes that plan sponsors that use private equity investments—which are not very liquid—would want a stable workforce and good employee tenure.

Including private equity funds in TDFs depends on the objective of a particular TDF strategy and whether it will help participants reach their retirement goals, Czochara says. She notes, however, that they offer great diversification and returns.

“Private equity and hedge funds have been something we have evaluated, and we will continue to review private equity, especially as new products for DC plans are introduced,” she says.

Tshudy says there are several considerations for building custom TDFs—most structural. Plan sponsors will want custom TDFs with tailored risk levels and glide path shapes and lengths based on participant demographics. He says SEI also looks at the plan sponsor’s total benefits package.

An example Tshudy offers is that if a plan sponsor has a frozen or closed DB plan, the glide path of a custom TDF could be tailored so that as participants age out of the DB plan, the TDF will continue to move them along that pension track, reducing risk. Another example is for a plan sponsor in an industry sector in which employees retire early due to the physical demands of the job. In that case, a custom TDF glide path would factor in a shorter investment time horizon and the need for funds for a longer retirement, Tshudy says.

“We try to stress and emphasize diversification because, after a market loss, participants may react by pulling their funds out of the investment and that just increases their losses,” Tshudy says. To build a custom TDF, he recommends plan sponsors look at asset classes that are underappreciated—typical stocks and bonds don’t cover everything participants need. “They should look at high-yield emerging market debt and we also favor managed volatility equity strategies. They give equity-like returns without volatility. The goal is to smooth out volatility,” Tshudy says.

Protection Near Retirement

Some say the COVID-19 pandemic has shined a light on the fact that defined contribution plans do not effectively de-risk those closest to retirement. Swann says downside protection is critically important when selecting off-the-shelf TDFs or designing custom ones. “Investment losses near retirement age are meaningful because balances are bigger and time is short,” he says.

Swann says most off-the-shelf TDFs are aimed at getting the highest returns possible to be competitive, so some are invested too much in equities around the retirement age. Plan sponsors can use customized TDFs to dial in the risk they want to take.

In 2014, regulators agreed that plan sponsors can include deferred income annuities in TDFs used as a qualified default investment alternatives (QDIA) in a manner that complies with plan qualification rules. And the Setting Every Community Up for Retirement Enhancement (SECURE) Act, passed last year, has a checklist of factors sponsors should consider when selecting an insurance carrier to offer a guaranteed lifetime income product in an attempt to quell plan sponsors’ fears about their fiduciary duties.

Czochara says investment products designed to provide retirement income are extremely important to help retirees spend reasonably and not outlive assets, and tying retirement income to TDFs or managed accounts—whichever is a plan’s default option—“makes sense.” While there hasn’t been much demand from plan sponsors, she says there will continue to be innovation and new solutions to deliver retirement income.

“We’ve seen a couple of developments in off-the-shelf TDFs that offer retirement income as part of their design, and we think that’s a positive evolution,” Swann says. “We’re seeing single annuities, deferred annuities or a combination of investment-based retirement income solutions.”

However, he says participants tend to take their money out of the plan when they retire. “The cart is a little bit before the horse at this point,” Swann says. “We’re not seeing a demand now, but what participants want will determine what plan sponsors do.”

Swann notes some trade-offs to offering retirement income solutions in TDFs could be high costs, being locked in to a provider or a fiduciary hurdle of monitoring guaranteed products.

Evolution of TDFs

“We would say that more than participant age and whether participants have access to a DB plan, to be the most effective at meeting their needs, a TDF has to be designed at the individual level,” Czochara says. “TDFs should be personalized using data such as gender, salary and salary growth rate. For example, two participants that are the same age could be compensated differently. Data can help construct a better asset allocation for them.”

Czochara says it is NTAM’s view that this is the way TDFs will continue to evolve.

“Right now, even if a plan sponsor uses a custom TDF, it still is the same for two participants with different situations,” she adds. “The key benefit of personalization is it uses a clear view of their goals and their assessment of retirement readiness. Personalization could increase participants’ commitment to their plan and hopefully their confidence, and, as such, maybe they would save more. Think about something you own that is specific to you. You want to take care of that.”

Explaining how it would work, Czochara says there wouldn’t be funds on the menu with dates, like a 2035 Fund. It would be based on four underlying components from the plan’s core investment menu—growth, diversified growth, fixed income and cash. Each participant would be invested in a unique combination of those four components, she explains.

Czochara adds that there would be a check-in on an annual basis. “Participants would receive an automated message that tells them their progress and gap from their goals,” she says. “An investment manager offering this service would continue to adjust the glide path based on information such as age, updated salary, target retirement age and amount they are saving.”

Participants being able to achieve their target income replacement is the ultimate measuring stick for retirement plans and their investments, Swann concludes. “It’s important to measure funds by their ability to help participants retire, not just by investment performance and comparison to peer groups.”