Vanguard Proposes Benchmarking Approach for Target-Date Funds

August 24, 2007 ( - Vanguard Investment Counseling and Research has suggested an approach to a problem that has bedeviled many plan sponsors otherwise attracted to target-date funds: how should they best be benchmarked?

In its paper, Vanguard said its benchmarking plan reflects the objective of these funds and could help investors obtain a clearer picture of the long-term returns a fund provider expects to deliver, a fund’s track record relative to those expectations, and the relationship between fund returns and a “typical” investor’s ability to finance retirement.

“Target date funds pursue a unique, goals-based objective, using a combination of securities and ‘packaged’ advice to help investors accumulate sufficient resources for retirement,” the Vanguard researchers wrote. “Existing benchmarks provide no sense of the funds’success in meeting this objective. It is almost as if a tour guide agreed to take a traveler from A to B, but never clarified how the pair would get to B, or even precisely where B was. The traveler would be lost.”

The investment company points out the current common approaches to benchmarking include:

  • Comparison with Morningstar or Lipper peer groups.
  • Custom peer-group benchmark or custom index benchmark. Fund performance is compared with the return of a hypothetical portfolio with an identical asset allocation.
  • Target date fund indexes. An index provider creates an index for each target maturity date and shifts the asset allocation toward a more conservative mix as the maturity date approaches. Asset class returns are represented by asset class indexes.

Vanguard says that because existing benchmarks are typically used to assess six- or 12-month performance, they emphasize short-term volatility rather than long-term return which is the more important consideration for a target date fund investor.

Answering ‘Critical’ Questions

Vanguard proposes two benchmarks that it says will help investors answer critical questions about a target date fund’s performance: the return required by the typical investor to generate enough retirement dollars and the fund performance relative to the investment manager’s return expectations.

The first proposal focusing on the investor’s savings target includes three steps, according to the report:

  • It determined the savings target for a typical investor at retirement (age 65). It established the savings target as the amount of money that will allow investors, in 85% of the scenarios, to maintain their pre-retirement standard of living during retirement, without running out of money by age 95.
  • Next it identified the rate of return required to achieve the savings target over a 40-year savings period. This analysis does not incorporate financial market uncertainty or the lifecycle pattern of asset allocation. Vanguard’s calculation based the amount and timing of the investor’s contributions on the lifecycle pattern of income and the average contribution behavior of the 401(k) participant population for the given income level. Based on these retirement plan savings rates, an investor would need to earn a real return of 1.6% to 3.8% to reach the savings-sufficiency target by age 65.
  • The final step established the required rate of return with a margin of safety. Vanguard recognized that a number of individual or 401(k) plan specific factors could change the wealth accumulation pattern.

The second proposed benchmarking approach specifies what return an investment manager expects to earn and then reports actual returns relative to those expectations.

align=”left”>”Current benchmarking approaches suffer from a lack of transparency,” the Vanguard authors conclude. “What constitutes retirement security—and the expectations that inform the investment manager’s plan for helping investors achieve it—is never made clear. As we have discussed, these two new approaches have a variety of merits as benchmarking tools that could potentially fill the information gap that has prevented investors from conducting a meaningful evaluation of these powerful retirement-savings vehicles.”

The Vanguard report is here .