Dan Oldroyd, Executive Director, J.P. Morgan Asset Management, discussed one growing trend among TDFS – deciding to use a “custom” TDF in the plan. He first explained that TDFs have three parts: the glide path, the manager that implements the glide path, and the assets that go into the fund. These parts usually come as a package deal, but a custom TDF allows the parts to be manipulated to best fit the plan’s needs.
“Custom” means different things to different people, he said. Some may consider a custom TDF to include just a custom glide path – but if one manager is still in charge of that glide path, Oldroyd said this is more like a separate account. Varying levels of active risk are another customization option, he said, whether the plan wants to use more index managers rather than active managers, for instance. “Multiple flavors exist,” he explained, “Coke, Diet Coke, Diet Coke with Lime,” but essentially they are the same thing.
Why Go “Custom”
However, if a plan sponsor wants to create a custom glide path, using an assortment of target-date investment managers, and develop a TDF that fits his or her specific plan design needs, than a custom TDF may be appropriate to use.
Oldroyd explained that there are four considerations when deciding to go with a custom TDF: 1) What are the plan objectives?; 2) What sort of participant behavior can you expect?; 3) What are the capital market assumptions you’re working with?; and 4) What went into the investment policy statement (IPS)?
When considering the plan objectives, the sponsor needs to ask how it is measuring success and what success will mean: is it getting their participants to retirement as safely as possible, or hedging against longevity risk? Oldroyd says plan characteristics will help answer these questions. Plan characteristics include participant behavior, which goes beyond demographics, he noted. How much are they saving, are they withdrawing and how often, when do they do it, and how might that evolve over time are just some of the questions to consider, according to Oldroyd.The capital markets assumptions speak to the risk and return characteristics in glide path. “When you take your TDF off the shelf, you’re taking that manager’s assumptions as well. With a custom TDF, you can choose your own assumptions,” Oldroyd said. If going off the shelf, a sponsor should either match or at least be flexible about the manager’s market assumptions. Lastly, Oldroyd said a good investment policy statement should address TDFs. “Are you just investing the asset classes in a core menu? Or can other asset classes come in, like commodities or equities?”
Josh Cohen, Defined Contribution Practice Leader for Russell Investments, continued the TDF conversation and honed in on diversification. He made it clear that diversification is not a “magic bullet for higher returns” nor will it make up for not saving enough or not being in a TDF to begin with. Those are the first steps, he said, but it doesn’t stop there. He sees three parts to diversification: manager diversification, asset class diversification, and how to address inflation risk.
Cohen explained that a common argument he hears from sponsors is “We’re defaulting people into these funds; let’s just keep it simple and basic.” Cohen rejects that approach – “That’s not what we’re supposed to be doing as fiduciaries. Our participants who are being defaulted into these funds want us to use our best idea.” And there’s no better idea than using all three kinds of diversification, he said.
As for why it is important to have manager diversification in a plan, Cohen noted that the industry has worked hard the last 10 years to move to a more open-architecture, non-proprietary approach for funds. Now, it seems to Cohen, that everything has been rebundled to single-manager type funds. He used an Olympic decathlete as a metaphor: the decathlete is considered to be the best of the best; they excel at 10 different sports. But if you look at his performance at each of those 10 events, he is never the best at that single event – the individual gold medal winner’s always out-performs the decathlete.
The same holds true for investment managers/TDF providers, he said. When all the funds are from the same good organization, no one manager is ranked as the best in all asset classes, but sponsors can choose the managers that are the best in their individual categories.
Having diversification in asset allocation does not mean we should be adding special asset classes in the core line up, said Cohen, but it can be done in a “portfolio context.” He also noted that alternative asset classes do not mean hedge funds, private equity, or private real estate – “Maybe in a few years we can talk about those, but there’s a lot of lower hanging fruit before we get there,” he said. “We don’t just want equities to be the only thing to drive the ride our participants are on, it’s good to have other asset classes. Not only does it lower overall volatility, but it provides different drivers.”When referring to inflation diversification, Cohen said TDFs are not going to hedge against inflation. “There’s a lot of marketing or scare tactics about the inflation issue,” he said. “TIPS, commodities, REITs… all provide different things. It’s a balancing act. You can reduce volatility, but you also decrease expected return…. We think 10% allocation of real assets, not including TIPS, to a portfolio does make sense from a diversification standpoint without giving up too much in performance. Towards end of glide path, we think there is a case to add more TIPS, probably in moderate amounts.”
Craig Lazzara, Senior Director, U.S. Equity Products for S&P Indices discussed how TDFs can be benchmarked. The problem with benchmarking these funds is that there are a lot of moving parts, he said. “TDF managers can add value both with asset allocation and selection decisions, and ideally a benchmark would help a user evaluate both of those sources of value-added,” he said.
There are three main ways in which sponsors can benchmark TDFS, according to Lazzara: custom benchmarking, which makes sense for a custom TDF portfolio; “the problem is they are necessarily manager driven. It’s impossible to say anything good or bad about the manager’s judgments on asset allocation,” he said. The second option is model-driven benchmarks, which means that an index provider/benchmarker will have a model for the 2030 fund with X% in this and Y% in that, he explained. This gives you the ability to say something about asset allocation, but the problem is it makes you accept the assumptions of the index provider’s models, which you may or may not be willing to do. The last – and best – option, according to Lazzara, is the representative benchmark. It is designed to reflect market consensus and facilitates asset class and securities selection analytic discussions.
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