2015
TDF Buyer’s Guide

Multidimensional Funds

Finding the right target-date funds for your plan.

Analyzing whether your plan has the right target-date fund (TDF) suite for your participants should mean much more than looking only at performance and fees. “Dig in. That’s the big thing,” says Nathan Voris, director of sponsor and workplace investment solutions at Morningstar Investment Management in Chicago.

“Do the analysis, and figure out what the best fit is for your participants. It is very easy to choose the lowest-cost option; nobody is going to get sued for doing that,” he says. “But appropriateness is what you should look for: ‘I’m going to pick the best glide path for my participant demographics.’”

Shawn Sanderson is seeing sponsors increasingly do an in-depth re-examination of the target-date funds they use for the qualified default investment alternative (QDIA).

“Early on, after the Pension Protection Act [PPA] in 2006, the default was to adopt the plan recordkeeper’s solution,” says Sanderson, a Rochester, New York-based senior investment consultant at Manning & Napier Advisors LLC. “Now we are starting to see assets flow out [to other TDF families]. It is important to step back and ensure that the plan’s QDIA aligns well with the participant demographics and with the plan sponsor’s goals.”

Analyzing target-date funds’ effectiveness for participants is both an art and a science, says Mark Olsen, managing director of adviser PlanPilot in Chicago. “Science tells you one thing: The numbers are the numbers,” he says. “But there is an art to it, too. It is not just about numbers; you need to look at it from an organizational perspective.”

Here are six questions to ask when analyzing whether your target-date fund family is still right for your plan.

1. Have major changes been made at the employer or plan? Beyond the routine quarterly and annual reviews many firms do for investments, Morningstar typically thinks about performing an in-depth analysis of a selected target-date fund, to determine if it is still the best match for a plan, under two types of circumstances, Voris says. He suggests doing a planned, periodic analysis every one to three years—perhaps every three for off-the-shelf funds, and every year for plans with custom target-date funds. It is also worth doing an analysis after a significant corporate event or plan-design shift happens, he observes. For example, an employer may freeze its defined benefit (DB) plan, alter its match formula substantially or reach a new labor agreement with unionized employees that will reshape the plan participants’ salary curve.

Adviser Mark Ray sees more sponsors re-examining their choice of target-date glide paths as they make plans to conduct a re-enrollment, usually done for nonparticipating employees and those participating below a certain deferral threshold. These sponsors have become more conscious of retirement readiness as a goal, having seen a gap analysis of their participants’ retirement savings, says Ray, a principal at Praxis Consulting in Sacramento, California. “Sponsors are looking at, ‘Do we have a sizeable gap in outcomes, and, if so, how do we find a way to close that gap?’” Changing the target-date glide path selected can be a piece of that response, he says.

2. Are these funds the best fit to help meet the sponsor’s goals? Many sponsors have likely not stepped back and seriously considered what goals they want their QDIA to achieve, Sanderson says. To do that now, “it comes back to understanding: Why are you offering this benefit—what are you trying to accomplish? And how do you measure success?” he says.

Having clarity about their objectives for the target-date funds is paramount for plan sponsors when evaluating their funds’ effectiveness, says Holly Verdeyen, director, defined contribution (DC) investments at Russell Investments in Chicago. “A committee should lay out its basic, fundamental target-date fund beliefs,” she says. Some sponsors may believe a glide path should be managed up to the retirement date, and others may think it should be managed through retirement. Some sponsors want to prioritize limiting volatility as much as possible, while others feel comfortable with more volatility in return for more growth potential. Some may prefer active management in these funds, and others favor passive. Some may see the need for a more global, diversified allocation, while others feel comfortable with portfolios having a home-country bias.

“In target-date fund management, there is not really any right and wrong,” Verdeyen says. “It’s more, what objective are the target-date funds trying to achieve?” Then a sponsor needs to ask: How does that mesh with what my plan’s participants need?

Sponsors should decide what retirement-income results they want for participants and whether the plan’s current target-date funds work well in helping them reach that. “On the pension side, oftentimes as employers were creating a defined benefit plan, they thought about: What is the targeted income-replacement ratio?” Olsen says. “Most employers don’t look at it with the same lens for the defined contribution plan. Some of the more forward-thinking DC plan sponsors have that mindset.”

3. Do participant demographics mesh with the funds’ assumptions? Frequently, sponsors collaborate with both an adviser and his recordkeeper to do a demographic analysis, Sanderson says. Recordkeepers can provide detailed information about replacement rates and retirement readiness across the participant base. “Now, more than ever, you have access to a great deal of plan-specific data,” he says. “So you have an opportunity to take a deep dive on that census data.”

Most target-date managers created their funds’ glide path by making a series of assumptions about average American workers, Verdeyen says. “It is my contention that a lot of plan sponsors are unaware of the many assumptions their target-date fund manager made when it developed the glide path,” she says. “Many of these target-date funds were designed for the ‘average’ American worker. But what is [the managers’] definition of ‘average’?”

In designing its glide path for off-the-shelf funds, an investment manager makes assumptions about variables such as average salary by age, savings rate, employer match, future wage growth, the income-replacement ratio needed in retirement and whether an employee has other retirement benefits, such as a pension plan, Verdeyen says. If a plan’s participants have substantially different characteristics, “there could be a serious mismatch [with the target-date fund family],” she says.

So, identify how the assumptions made by a plan’s target-date fund manager line up with the specific characteristics of participants in the plan, Verdeyen says. “Is the target-date fund family you have right for your work force?”

4. Does this glide path design make sense, given participants’ behaviors? What a plan’s participants actually do influences what glide path design works best for that group. Look at behaviors such as participants’ saving patterns, Sanderson says.

“Did they start saving early and continue to put aside a good portion of their paycheck, so that later they have the flexibility to continue to pursue growth?” he says. “If participants had a late start in saving, they may need to focus more on preserving their wealth in retirement, extending their retirement assets for as long as possible.”

Also, when do participants actually retire? “You really have to know your employee population,” says Michael Sanders, a principal at consultant Cammack Retirement LLC, in New York City. “In higher education, for instance, many people work into their 70s and even 80s. But at a company with [mostly] manual-labor employees, many people probably can’t work past age 62 or 65.”

Retirement patterns influence what glide path and asset allocation work best for older employees in particular. “The first 10 years of a career, almost every target-date fund family treats about the same: The most aggressive and least aggressive are still fairly close together in allocations,” Sanders says. Later in the glide path, the allocations and risk profiles of these fund families can differ considerably, he notes.

And look at what people do with the money when they leave the company, Voris advises. Do they tend to take a lump sum, or do they keep the money in the plan and gradually withdraw it in retirement? “If a data analysis shows that retiring participants are using their account to generate regular retirement income, that could lead to a ‘through’ approach” in the glide path, he says. “If people tend to take a distribution, that may lead you to a ‘to’ design.”

5. Has the glide path changed since you picked the funds? “We have seen some fund families in the past 12 to 18 months announce that they are increasing the use of equities in their glide path,” Voris says. That is not necessarily a bad thing, but sponsors should look at whether changes that have been made to the glide path make sense for their participants.

“Since target-date funds are an outcome-based strategy, it can be difficult to tell whether a fund is on track to do what it’s supposed to do if the glide path keeps changing,” Verdeyen says. “Glide path stability is highly important to assess whether target-date funds are on track to give participants the replacement ratio they need.”

If a target-date family frequently changes its glide path, that is a red flag for a sponsor to investigate, Verdeyen says. “A sponsor needs to ask the manager, ‘Has there been any change in the objective of the target-date funds?’” she says. “Also understand, what are the old assumptions that were made in designing the glide path, and what are the new assumptions?

The main reason some fund families shift the glide path frequently is that their capital-markets assumptions have changed.”

Studying an analysis such as the glide path stability score (GPSS) given to target-date providers in the “Ibbotson Target-Date Report 1Q 2015” can help a sponsor start putting changes in context. As Voris says, “You can take that and drill down and say to the manager, ‘OK, why did you make this change? And did you publish the change with your rationale, or did you slip it under the radar?’”

6. Does the funds’ risk profile work for participants? Most plans with target-date funds still use the off-the-shelf type, says adviser Donald Jones, director at Fiduciary Doctors LLC, an independent fiduciary firm in Gilbert, Arizona.

Many sponsors simply went with their recordkeeper’s target-date fund family, without understanding whether its risk profile was compatible with that plan’s participants, he says. Often, they still do not have a good handle on the risk profile’s fit, he says.

Plan committees need to ask themselves, as fiduciaries, how much risk they feel comfortable letting their target-date funds take for participants, Sanders says. “If you have target-date funds that are really aggressive, that’s something you have to take into consideration,” he says.

Consider volatility, not just in terms of past results, but the future as well, recommends adviser Jim Phillips, president of Retirement Resources in Peabody, Massachusetts. For instance, weigh the impact that rising interest rates will have on a portfolio’s choice of fixed-income investments. “Sponsors need to make a decision about what will give the smoothest practical ride to participants using the funds,” he says. “The investment piece is more than what’s had the highest rate of return over the past three to five years.”

Doing this risk analysis gives sponsors a good opportunity to examine how they educate participants about these funds and their risks, Phillips says. “As a best practice, it makes sense that after you’ve done that analysis, let people know what to expect,” he says. For example, “These long-dated funds are very equity-rich, and as a result they are likely to have good long-term returns, but in the short term that can create volatility.” —Judy Ward

Documenting a TDF Analysis
“It is really important that this is a documentable process,” notes Mark Ray, of Praxis Consulting. “As long as you have a process in place and it makes sense, then it’s defensible.”

Ray recommends recording an analysis of target-date funds from the beginning. Praxis starts the process with a questionnaire for the plan committee; the committee is asked what it sees as the plan’s purpose—accumulation only vs. accumulation and distribution—and what distribution and in-service options the plan offers, among other questions.

Second, a sponsor and its adviser should document how participant demographics—ages and asset allocation—participant behavior and the employer contribution level affect desired plan outcomes, Ray says. For example, do most people keep their money in the plan or roll it out at retirement?

Third, a committee needs to detail its decision as to why the selected asset construction and glide path were chosen. Specifically outline how it reached this decision, Ray suggests. “We have a three-page document we go through with a committee,” he says, “and we make sure the committee signs off on it.”

With plans that have never performed a major target-date fund re-evaluation, “We say, ‘Let’s peel this all the way back and look at it as if you were going to pick a target-date fund family for the first time’” says Michael Sanders, of Cammack Retirement LLC.

“At the end of the day, the target-date fund family you have might still be the right one. If so, great. You have a report on file that proves you did your due diligence.” —JW

2015 PLANSPONSOR TDF Buyer’s Guide

Two significant themes can be inferred from this year’s collection of data for the 2015 PLANSPONSOR Target-Date Fund (TDF) Buyer’s Guide: 1) Asset managers are deeply committed to target-date fund solutions, as indicated by an exceptionally high survey participation rate, and 2) in their evolution, target-date fund solutions have moved far past any predicted 2.0 stage.

Target-Date Industry Overview
Target-date fund solutions grew to $1.3 trillion in assets as of the second quarter of this year, marking one of the fastest growth rates among investment products. Approximately 85% of target-date fund assets reside in defined contribution (DC) plans, which is consistent with the widespread acceptance of the funds as a qualified default investment alternative (QDIA). Of the total target-date fund market, 59% of assets are in mutual funds, 27% in collective investment trusts (CITs), 13% in custom solutions and less than 1% in insurance separate accounts and variable products. The following analysis is based on the 72 off-the-shelf or prepackaged products listed in this print edition of out target-date fund buyer’s guide, excluding custom solutions.

Investment Attributes
A core part of any due diligence process is the examination of an asset manager’s philosophy and process—factors we set out to identify via product attributes in this year’s survey. The use of passive management and of unaffiliated investment managers both speak to the target-date provider’s approach or procedures. 

The evolution of target-date funds has proven that not all is black or white—or, in this case, active or passive. About 40% of off-the-shelf target-date fund families—28 of the entries in our guide—use a hybrid method of portfolio construction, meaning the underlying funds are a blend of active and passive management. Another 37%—27 suites—reside in fund families that primarily use active underlying funds, and 23% of assets—17 entries—are in fund families that primarily use passive underlying funds.

In the case of target-date fund strategies, open architecture is the presence of an unaffiliated manager overseeing at least one part of the portfolio, whether it is an underlying single asset class or the overlay of asset allocation and glide path management.

More than half (55%) of off-the-shelf products now feature unaffiliated managers. However, only 16% of such funds’ assets are managed by unaffiliated managers, as long-standing proprietary target-date fund strategies such as the Fidelity Freedom Funds and Vanguard Target Retirement Funds continue to resonate with plan sponsors.

If none of the 80-plus prepackaged target-date products seem to be appropriate for your participant population, then perhaps a custom solution should be considered. Custom target-date funds can encompass one or several services, including but not limited to glide path construction, asset allocation and ongoing advisement, whether it is discretionary or nondiscretionary. —Bridget Bearden