The Markets March 8, 2019

Some Say Investors Are Better Served by Tactical TDFs

The Great Recession prompted many target-date fund managers to begin to consider tactical glide-path deviations based on market conditions and forecasts.
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Art by Jenice Kim

Art by Jenice Kim


According to the PLANSPONSOR Target-Date Fund Buyer’s Guide, 55% of target-date fund (TDF) providers now employ some type of tactical strategy in the ongoing management of their products.

Of the 18 fund managers that allow for tactical deviations, 78% may deviate from the glide path in all of their TDF suits, while 23% use a deviation in some offerings but not in others—for example using tactical deviations only in some TDF vintages.

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SEI Institutional has long employed tactical strategies to its defined benefit plans, and seven years ago the firm began implementing tactical management within its target-date series, says Jake Tshudy, director of defined contribution investment strategies at SEI Institutional in Oaks, Pennsylvania. SEI does this by including the Dynamic Asset Allocation fund as one of the underlying funds in the series, Tshudy says, with its contribution to the series never exceeding 10%. As participants approach retirement, the allocation to the Dynamic Asset Allocation fund is brought down to 0%, he says.

The fund manager looks out for economic challenges and places trades that are high conviction for the longer term, he says. For example, “the most recent large bet the fund took was to go short on the Euro. At the same time, if we decide there is a longer-term opportunity with high yield and emerging debt, we might make those trades in the fund if we think we are going to hold those positions for a long time,” Tshudy says. “The fund has a high tracking error because it is meant to exploit longer-term bets.”

In addition, SEI has added a risk parity fund tied to volatility that takes a similar approach but trades with more frequency, Tshudy says.

Prudential’s Day One target-date fund series also has the ability to react to significant market events, says Doug McIntosh, vice president, investments, at Prudential Retirement in Newark, New Jersey. “There is a firm-wide reassessment of market environments on an annual basis, and our portfolio managers update their capital markets forecasts every quarter,” McIntosh says. However, the Day One funds typically only adjust their holdings annually, he says.

‘Remaining True to the Glide Path’

“There is a definite place for tactical moves,” McIntosh says, “whether to equities, fixed income, commodities, real estate or Treasury Protected Securities. However because target-date funds are long-term products, we also want to make sure we are remaining true to the glide path. … We are focusing more of our intellectual horsepower on the long term to get that right.”

This is why the Day One funds typically only permit deviations in the 50 to 100 basis point range on alpha and 1% on volatility, he says. Like SEI’s Dynamic Asset Allocation fund, this tactical approach is dialed down as people approach retirement. “The 2020 fund ought not to be in a place that leaves it vulnerable,” McIntosh says.

At TIAA, the TIAA-CREF Lifecycle Funds are overseen by a monthly committee of asset class leaders and economists, says John Cunniff, managing director at Nuveen and manager of the TIAA-CREF Lifecycle funds. Four years, ago, TIAA incorporated a tactical component, he says. “The tactical management component makes adjustments on a forward-looking basis and is limited to no more than +5% or -5% of the portfolio,” Cunniff says. “We see ourselves as an extra player on the team adding alpha.”

Like Prudential, TIAA says the overriding principle guiding the TIAA-CREF Lifecycle Funds is the long-term glide path, followed by the relative performance of the underlying portfolio managers. Then the tactical element comes into play.

As for how much the tactical component boosts performance, Cunniff says the more tactical approach has added 10 to 25 basis points to the funds’ performance over the past three years.

Taking Tactical TDFs a Step Further

Francisco Gomes, professor of finance at London Business School, recently issued a report calling for tactical target-date funds to go a step further by relying on short-term market data based on variance risk premiums to adjust funds’ asset allocations on a quarterly basis. The paper argues TDFs could be far more tactically aggressive, with portfolio turnover potentially ranging as high as 200%. By comparison, according to Gomes’ paper, “Tactical Target Date Funds,” portfolio turnover for a standard TDF in the marketplace today is far lower than this. Gomes argues greater tactical leeway being given with TDF managers could minimize downside risk.

Tshudy says that this approach to minimizing risk is more or less in agreement with its Dynamic Asset Allocation and Multi Asset Accumulation funds. “We agree with the smoothing of risk. The difficulty of this approach, where the rubber meets the road, is that protecting the downside does cause issues when the market is trending upward,” Tshudy says.

In addition, Gomes’ theory relies heavily on variance risk premiums, Tshudy adds. “That could be exploited to the point that the predictive power is minimized as other investors become aware of the approach,” he says.

McIntosh is unsure whether relying on a variance risk premium is well suited to a target-date series of 12 funds. “The notion of allocating on a changing risk premium is one I have seen used in the defined benefit world,” he says. “That concept is well suited to the DB world, where you are making one single omnibus trade, rather than trading across 12 funds. Across numerous portfolios, it becomes a little bit complex from a trading perspective.” He also thinks a 200% annual portfolio turnover is quite high.

Cunniff notes that Gomes’ backtested theory would permit a tactical target-date fund to trade 10% of its portfolio either up or down to look for “anomalies within volatility in order to find alpha.” This range results in “a band of 30%. That is higher than most of the industry players—more than double the average,” he says.

Client Service March 6, 2019

Clear Ground Rules Essential With 3(38) Fiduciary Clients

Experts share strategies for helping advisers taking on 3(38) fiduciary clients understand how they can set up the right processes and procedures—up front—for dealing with client concerns and questions about the investment menu.
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Art by Linda Liu


Phil Edwards is principal of Curcio Webb, a firm that helps both defined contribution (DC) and defined benefit (DB) plan sponsors identify the most appropriate service providers for outsourced 3(38) fiduciary investment management.

Besides consulting with plan sponsors, Edwards explains, a big part of this business involves working with the retirement plan advisers and other entities that provide Employee Retirement Income Security Act (ERISA) Section 3(38) outsourced fiduciary investment management services. Edwards says providers in this space are constantly reevaluating their service models to promote client outcomes and improve their own returns from a business growth and efficiency perspective.

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According to Curcio Web Chief Compliance Officer and Consultant Elliot Raff, it doesn’t happen very often that a plan sponsor client decides to go down the 3(38) investment outsourcing route and totally misunderstands what they are signing up for in terms of handing over fund menu discretion. However, there are occasionally some misunderstandings about the nitty-gritty details, which can be unsettling for clients and the adviser alike. As such, Raff highly recommends advisers moving into the 3(38) area put strong processes and procedures in place—up front—for dealing with client concerns and questions about their investment menus.

In their experience as 3(38) matchmakers, Edwards and Raff say there are two basic things advisers must do at the outset of this type of a relationship to prevent misunderstandings and even potential compliance lapses. The first and simper of the two agenda items is describing in sufficient and written detail all the specific duties and responsibilities being taken on by the 3(38) provider—as well as detailing in the same specific manner which responsibilities will remain with the plan sponsor client.

“We make sure to work with our clients to go way down into the weeds and create a very clear understanding of who is responsible for what decisions and on what timeframes,” Edwards says. “That clarity is critical. Of course, sometimes it’s going to be an evolving situation, especially with very large plans that may decide to almost do a trial period, where they delegate increasing portions of the responsibility to the 3(38) provider over time as confidence increases. This type of thing should also be clarified.”

The second and more subtle agenda item is to ask clients, what is the objective of the retirement plan and how will outsourcing the investment management support that goal?

“The adviser and the client must be able to answer the question of to what goals they are managing and how 3(38) service will be beneficial,” Edwards says. “This is important for DC plans but especially for DB plans that are bringing in an outsourced chief investment officer (OCIO). DC plans have a more straightforward and open-ended objective of growing participant accounts, while DB plans have much more variability in terms of time horizons and goals.”

Beyond these two points, Raff emphasizes the importance of making sure plan sponsor clients know the retirement plan committee must remain highly active even when a 3(38) manager is brought onboard.

“Plan sponsors must take as much time as necessary to understand these issues,” Raff says. “Advisers can help guide them by asking, what are the functions you want to hold onto? What functions are you comfortable handing over? And what functions do you really want to get rid of? Advisers and sponsors need to start dealing with these questions at the earliest stage of the outsourcing process.”

While Raff and Edwards say they have broadly had success finding appropriate fits between plan sponsors and providers of 3(38) services, some jobs require more up-front legwork than others.

“We occasionally see companies that may be thinking about jumping on the bandwagon without really understanding why or what it means to give over discretion to a 3(38) provider,” Edwards says. “They hear about outsourcing as a way to reduce their fiduciary liability and the amount of time they spend on the plan. We have to teach them that 3(38) outsourcing is much more involved than that.”

Edwards points out that, surprisingly, there is no strong correlation between plan size and the sponsor’s quality of understanding of the plan’s goals and objectives.

“We’ve met several multi-billion dollar plans where there has not been a well-defined goal,” Edwards says. “It’s not like the committee didn’t have the expertise to think about this stuff, they just haven’t had the time. And then we have much smaller plans that we meet that have clearly been able to spend a whole lot of time thinking about this—and so they are much better prepared to get started.”

Joe Connell, partner, retirement plan services, at Sikich Financial (and a former winner of a PLANSPONSOR Plan Adviser of the Year designation), says he has not had much experience with clients being confused about what 3(38) relationships entail—even though he has been offering 3(38) services for years.

“I have not had any issues with any client or participant asking for a fund we would not feel comfortable using,” Connell says. “You must set expectations up front and be very clear about the role of a 3(38) adviser and how this role does change the decisionmaking and fund evaluation process for the plan sponsor.”

Connell adds that the adviser should be mindful of whether a client is a good fit for 3(38) services. Some plan sponsors just won’t feel comfortable giving over discretion to an outside adviser, and that’s okay. These plans may be a better fit for 3(21) service, wherein the investment process is much more collaborative and discretion remains with the sponsor.

“The plan sponsors we assume 3(38) services for are looking to remove that decisionmaking from the committee level and looking to us to provide the expertise on fund decisions,” Connell explains. “So, they are very supportive of us saying ‘No,’ when we have to, to a fund addition that would not meet our investment policy statement criteria.”

In Connell’s experience, when a plan sponsor brings on an outside discretionary fiduciary under ERISA Section 3(38), the client is not necessarily trying to remove themselves entirely from all plan-related decisions. Instead the move is more about getting the right expertise in place for the challenging task of investment selection and monitoring, by the same token freeing up time for the plan sponsor to worry about other things.

“They are just looking to use our expertise in this specific area and allow themselves more time to focus on other plan related decisions and discussions,” Connell says. “They will be spending more time on plan design, participant services, education programs and other initiatives focused on their employees.”

Scott Matheson, managing director, defined contribution practice leader at CAPTRUST, echoes many of these points and says his firm continues to see tremendous growth in the demand for 3(38) services.

“In fact, nearly all of the adviser RFPs we filled out last year asked about 3(38) capabilities,” he says, “and many of those asked for 3(38) pricing, even if the intent of the plan sponsor issuing the RFP was the hire a 3(21) adviser. We have continued to invest in our resources and infrastructure to support the growth in our 3(38) business.”

To the question of friction points when hiring a 3(38), Matheson has a few additional thoughts.

“To the extent we see friction points with plan sponsors accepting a 3(38) engagement, it tends to come during the transition period as plan sponsor employees and/or committee members are settling into their newly evolved roles,” Matheson says. “Much of this, however, can be reduced or avoided by proper expectation setting and by advisers ensuring a good fit for plan sponsors before transitioning them to a 3(38) service model.”

Matheson agrees that plan sponsors that are very interested in the investment selection and monitoring process are likely not good fits to transition to a 3(38) approach and, as such, would likely experience more friction during a transition period. 

“We also find that 3(38) service models continue to vary considerably across the adviser community, with many advisers still accepting 3(38) assignments yet continuing to run investment decisions by plan sponsors before finalizing,” Matheson adds. “This is not much, if at all, different from how they were operating as 3(21) advisory fiduciary. The industry lack of a standardized service model/offering only adds to the potential for friction during transitions to 3(38) because expectations were often set during the adviser search/proposal phase of transitioning to 3(38).”

According to Matheson, part of the fuel behind the growth in 3(38) service can be tied back to the Great Recession of 2008 and 2009. He says the financial crisis forced many of CAPTRUST’s clients to reduce the headcount in their finance and human resources departments, and while the economy has improved significantly since that time, U.S. employers have not broadly added back the positions. Many companies, Matheson says, have fewer staff working on retirement plan administration as a result.

“Faced with financial market volatility, rising interest rates, regulatory scrutiny, and rising plan-related litigation activity, plan sponsors are looking for help managing their plans,” he says. “In some cases, they are turning to their plan advisers, asking them to do more on their behalf [as a 3(38) fiduciary].”

Matheson says it is important for retirement plan sponsors to understand that ERISA Section 3(38) does not define “investment advisers with discretion,” nor does it say “here’s a way to transfer more risk to your investment adviser.”

“Rather, it defines investment managers as distinct fiduciaries contracted with full discretionary authority over plan investments and making plan investment decisions,” he says. “An appropriately contracted and executed 3(38) arrangement frees the plan sponsor from the time involved in selecting and monitoring plan investment options and the liability associated with these decisions. As explained in ERISA Section 405(d), the plan sponsor and/or trustees of the plan are not liable for acts or omissions of the 3(38) investment manager, and are under no obligation to invest or otherwise manage any asset of the plan which is subject to the management of that investment manager.”

Plan fiduciaries must still monitor the work of the 3(38) manager to ensure plan participants and assets are being managed in a best-interest capacity, but that workload can be significantly lighter than managing the plan’s investment menu alone.

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