State of the Industry
A Target for Scrutiny
TDF selection requires careful analysis
Ever since the Pension Protection Act of 2006 (PPA) allowed plan sponsors to automatically enroll employees in a target-date fund (TDF) as the plan’s qualified default investment alternative (QDIA), plan sponsors have overwhelmingly opted to use the funds as their QDIA of choice.
According to the 2020 PLANSPONSOR Defined Contribution (DC) Survey: Plan Benchmarking, 81%% of plan sponsors offer a TDF to their plan’s participants, up from 61% in 2014.
“Over the course of the past 15 years, much has changed and evolved, but what hasn’t changed is the need to make sure we’re outcome-focused and getting it right with our target-date funds,” says Lorie Latham, senior defined contribution strategy at T. Rowe Price Associates in Baltimore. “Plan sponsors are taking a step back to ask what they’re looking to accomplish with their choice of target-date fund. How does it fit into their benefits profile, and what are they looking to solve for?”
One thing that’s clear, despite their ubiquity, not all target-date funds are the same, says Paul Zemsky, chief investment officer (CIO) for multi-asset strategies and solutions at Voya Financial in Mount Kisco, New York. Their underlying investments, and risk allocations, vary dramatically, as do the assumptions that go into their glide paths, or how their allocation changes as participants reach or enter retirement. The cost of target-date funds can also vary considerably.
Given this variation, lawmakers have recently asked the Government Accountability Office (GAO) to review these investment vehicles to evaluate whether the expenses and risk allocations in target-date funds are appropriate for the participants enrolled in them. It is an important question, given that, by the end of last year, the funds held $2.8 trillion in assets, a 22% increase over 2019, according to Morningstar.
Lawmakers aren’t the only ones who have concerns about target-date funds. A recent academic study found that some of the funds may take advantage of participants’ propensity to “set-it-and-forget it,” putting them into more expensive share classes within the fund family.
The study, “The Unintended Consequences of Investing for the Long Run: Evidence From Target-Date Funds,” assumed a closed-architecture fund, composed entirely of one family’s funds, but many target-date funds incorporate multiple managers, a practice that can have benefits for plan participants, Zemsky says.
“It can be hard to make the case that it’s in the best interest of participants to claim one money management firm is confident in every asset class,” he adds. “If the portfolio manager wants to invest in a certain asset class that the fund doesn’t offer, [he] can’t do so.”
Still, Zemsky contends that most target-date fund managers have the best interests of participants in mind when they’re building their funds. Plus, the crowded target-date space makes it difficult for asset managers not to make their offerings as cost-efficient as possible.
Even so, the study highlights the importance of the due diligence that plan sponsors must execute when evaluating target-date funds for, or already being offered in, their plan.
“We believe that plan sponsors have to spend extra time monitoring and reviewing their target-date funds,” says Elise Thiemann, investments director with Willis Towers Watson in Chicago. “It’s probably the most impactful decision that a fiduciary can make.”
It’s a responsibility that plan sponsors are taking seriously—spending time to search out the best plan for their participants, rather than simply going with the option offered by their current vendors. Only 23% of plan sponsors used their recordkeeper’s target-date fund selection in 2020, down from 67% in 2010, according to Callan.
Selecting the right target-date fund is important not only because it can ensure positive outcomes for participants, but also because improper or poorly documented selection could create liability issues for sponsors if their plan’s participants believe the target-date fund is underperforming.
That may be why nearly 70% of plan consultants said reviewing target-date funds is one of the top priorities for their clients this year, according to PIMCO. That study found that the top reasons plan sponsors changed their TDF were to reduce fees, improve performance, or to switch to either passive or an active/passive blend strategy.
While some plan sponsors may opt to use a customized target-date solution in their plan, even those that go with off-the-shelf options have many variables to consider. Cost is an important aspect for many plan sponsors, of course, but simply selecting a target-date fund with the lowest cost does not mean the sponsor has met its fiduciary obligations.
“One of the biggest mistakes that plan sponsors make is choosing a fund with low fees because they think it’s going to protect them from a lawsuit,” Zemsky says. “Cheap doesn’t mean you’re going to get the best value.”
A TDF with the lowest possible fees that fails to meet the needs of the participants is not the most suitable choice. That said, it’s important to keep an eye on fees during the selection process and then to make sure they don’t creep up. Larger plans—or smaller plans that grow over time—should attempt to negotiate lower costs and relationship pricing, where possible, says Todd Kading, president and co-founder of Leafhouse Financial in Austin, Texas.
Another option to keep costs down for some plan sponsors might be to switch from a target-date fund mostly invested in mutual funds to one that uses collective investment trusts (CITs), which offer similar benefits to mutual funds at generally lower costs.
Active vs. Passive
Plan sponsors that opt for a passive target-date fund need to understand that a manager will still make active decisions affecting that fund that the plan sponsor must evaluate.
“There’s no such thing as a completely passive target-date fund,” Latham says. “There are always underlying decisions and a manager preference that affects the glide path orientation.”
The starting place for many plan sponsors when selecting a TDF should be the objectives of the plan itself and whether the fund aligns with the plan’s goals for its participants, says Chris Herman, head of investment strategies, workplace investing at Fidelity Investments in Boston.
Plan sponsors must also evaluate the underlying investments in each fund series and examine its glide path to determine whether it will meet their participants’ needs, both now and in the future.
That gets trickier with participants at or near retirement, as the sponsor needs to ensure that its TDF manager’s roll-down in retirement—i.e., the post-retirement portion of the glide path—aligns with its participants’ distribution pattern, Thielmann says.
“The biggest risk in many target-date funds is the drawdown risk—that participants will take a big drawdown, particularly near retirement, that causes them to have to change their retirement plan,” Zemsky says. “Having a glide path that appropriately cuts risk as you get closer to retirement is probably the most important thing for a plan sponsor to consider.”
Plan sponsors with many retirees or near-retirees might also want to update plan documents to allow for partial distributions or systematic withdrawals, Latham says.
In total, more than 60% of 401(k) plan participants’ assets are in equities, with 28% in fixed-income securities, according to the Investment Company Institute (ICI). As the equity markets remain strong, it’s important for plan sponsors to remember that recent gains don’t counteract the need for regular performance reviews.
But evaluating the performance of a target-date fund presents some unique issues for plan sponsors, Thielmann says. That’s because the underlying holdings of the funds vary so dramatically, and their long-term objectives mean that short-term performance is not always the best indicator. For plan sponsors, the goal is to evaluate the performance of a TDF’s investment mix, rather than individual asset classes.
“It’s challenging because there aren’t great published target-date benchmarks,” Zemsky says.
A target-date fund that’s overweighted toward equities, for example, might appear to outperform its peers, Latham says. A useful benchmark, then, must include assets that align with those of the target-date fund and have similar goals.
“The benchmark is an important reference point for not only evaluating investment decisions, but for implementing those decisions as well,” Herman says. “It should align with the goal of the target-date fund strategy, and it should also represent intended asset class exposures. In addition, the benchmark should be transparent and understood by plan sponsors and participants.”
That task may soon get easier. A provision in the proposed Securing a Strong Retirement Act asks the Department of Labor (DOL) to allow plan sponsors to use a benchmark that blends various securities market indexes to build a gauge that can better demonstrate any specific fund’s performance.
In the meantime, it may make sense to bring in a third-party adviser to help evaluate a target-date fund.
“It’s the duty of the plan sponsor to be a prudent expert,” Kading says. “And if it’s not a prudent expert, it should engage someone that is. We don’t just look at the glide path, we are running a proprietary scoring system on underlying positions to understand why [a fund manager is] using one fund when there might be another with better risk-adjusted returns.”
Another factor that determines a TDF’s success is participation by employees, an area that the plan sponsor can influence by investing in wellness education or working with its providers to make changes to plan design, such as increasing the company match or implementing a re-enrollment sweep.
“Even a target-date fund can’t make up for a person who hasn’t saved any funds for retirement, and it’s not going to increase their chances of a successful retirement,” says Randy Welch, managing director and portfolio manager at Principal in Des Moines, Iowa. “The target-date fund will provide diversification, but it’s important to look at whether participants are saving enough to have at least a reasonable chance at a positive retirement.”
As with other fiduciary decisions, selecting and monitoring a TDF requires the plan sponsor to document the entire process, Herman says. That documentation process can look at each factor the sponsor has considered and include the rationale for the decision it ultimately made.
“Documentation provides a strong fiduciary armor against future litigation, as plan sponsors can point to their robust due diligence process,” Thielmann says.
It also helps with level-setting expectations and serves as a reminder for the investment committee if a fund underperforms expectations in the short term.
“It can go back to the documentation and say, ‘This is why we selected this target-date fund,’” she says. “In future years, during performance monitoring, there’s a solid foundation to judge performance beyond the quarterly benchmark. You can look at your objectives and ask whether this QDIA is meeting the goals it set out to meet. Is it meeting its stated objective?”