When measuring a target-date fund (TDF), “the key point is to shift our focus from measuring TDF against a custom index to actually meet the goal of achieving equal consumer discretionary spending pre- and post-retirement,” says Sabrina Bailey, global head of retirement solutions at Northern Trust Asset Management in Chicago.
“The defined benefit (DB) world has been using this approach for decades, and after the passage of the Pension Protection Act, their view of liability-driven investing increased significantly,” Bailey says. “In the DC [defined contribution] construct, the liability is the target retirement income and measuring the savings rate to keep up with that liability. For example, if an individual is on track for retirement or a plan sponsor has a strong plan design, they could take less risk in the investment portfolio and still achieve equal consumer spending pre- and post-retirement while avoiding a down market.”
Northern Trust outlines this more conservative approach to creating a TDF glidepath in its white paper, “What’s the Funding Status of Your DC Plan?” The paper notes: “Assets within a DC plan should serve a purpose, and that purpose is not to accumulate a large amount of excess assets over one’s working career. A DC saver’s excess assets may likely be used more effectively elsewhere during the accumulation phases, i.e. to pay down debt prior to retirement.
“Additionally, well-documented behavioral research studies indicate that the pain retirement savers experience from investment loss is greater than the joy derived from equal upside gain. Therefore, TDF investments should aim to meet the retirement liability, as opposed to exceed the liability,” Northern Trust says.
To accomplish this, Northern Trust’s TDF series, its Focus Funds, have a proprietary Income Replacement Rate Framework that allows the firm to determine the appropriate replacement rate for participants in different DC plans, Bailey notes. To accomplish this, Northern Trust “looks at what participants are making today; what they are saving; balances ; the plan design, including company matches, deferral rates and escalation; taxes; and the average retirement age,” she says.
Thus, as opposed to off-the-shelf TDFs that might predetermine an income replacement ratio of 75% or 80%, for a particular plan, Northern Trust might determine that it is actually 78%, and that will then let the asset management team know what the asset allocation should be for that particular plan, or even build a custom TDF, Bailey says.
Northern Trust’s TDFs are also built to provide downside protection, according to the firm’s white paper, “Glidepath Innovation to Drive Better Participant Outcomes.” The paper notes: “Our glidepath design and construction process utilizes our asset allocation philosophy, which builds on the importance of financial asset diversification, global equity diversification and inflation sensitivity.
“Financial assets, which include both risk control and risk assets, are diversified to potentially reduce volatility and seek to protect against downside market events. We employ these methodologies in a goals-based framework called goals-driven investing (GDI),” the firm says.
Northern Trust’s portfolio managers then look at a five-year forecast for economic activity and market returns. “Additionally, we consider a qualitative lens where, each year, key themes emerge that we believe will affect the economic and financial market landscape,” Northern Trust says.
The Focus Funds are also designed to take a participant through retirement, Bailey says. According to the firm’s DC funding status white paper, that is up to age 95. Northern Trust then “empirically encodes the federal tax code” into its TDF model, to account for tax, Social Security and health care” into the funds’ glidepath, Bailey says.
The Northern Trust Focus funds also “take lifecyle expenses into consideration by relying on academic studies and economic research” into spending patterns in retirement, Bailey says. Another key component is “human capital—but Northern Trust looks at human capital in a different way than our competitors,” she says. “We look at the present value of future savings in order to reach an individual’s retirement goals. Imagine you are participating in your 401(k) plan and saving $100 every two weeks. That is what we consider the human capital. It is a bond-like investment because it is contributed on a regular basis. The consistent savings allows you to take more risk in equities.
“As you get closer to retirement, the number of contributions will decrease, so we offset that with an allocation to a bond-like portfolio that has more income characteristics,” Bailey continues. “That drives our glidepath and goals-driven investing. The whole concept is to move away from a risk/return framework to look at the income the TDFs will provide.”
As Northern Trust notes in its funding white paper: “The objective for any target date fund should simply be to efficiently fund the retirement liability, enabling participants to reach those goals—not to outperform an index, generate higher total returns than other mangers or take unnecessary risk to grow assets in excess of the liability.”