Data & Research August 25, 2014

Creating a Sound Way to Choose TDFs

Plan sponsors thinking about putting target-date funds (TDFs) in their investment lineup must determine an implementation process that will support the plan’s goals, Towers Watson says in a white paper.
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“Are You in the Wrong Target-Date Fund? Now Is a Good Time to Reevaluate,” by Towers Watson, gives an overview of the growth of TDFs, and touches on guidance from the Department of Labor (DOL) issued in 2013. (See “EBSA Offers Tips for Selecting TDFs.”)

The funds have grown in popularity, notes David O’Meara, a senior investment consultant who specializes in target-date funds at Towers Watson Investment Services Inc., and now require plan sponsors to take more care with choosing the best one for their plans.

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In the wake of the Pension Protection Act of 2006 (PPA), O’Meara says, many plan sponsors adopted TDFs in fairly short order. “When they started, there were not a lot of product offerings,” he tells PLANADVISER. In fact, he points out that most plan sponsors selected a TDF that was associated with the plan’s recordkeeper, without any particularly rigorous due diligence, because the offerings appeared reasonable and could be implemented fairly quickly. “They saw that [speed] as a benefit to participants,” O’Meara explains.

The offerings now include more sophisticated products and expanded implementation options. Towers Watson points out that the DOL’s guidance provides plan sponsors an opportunity to revisit their exposure relative to plan objectives and participant needs. Active or passive management; custom or off-the-shelf and a process of due diligence are among the issues plan sponsors should think about when choosing a TDF.

O’Meara says a key factor for plan sponsors to consider is the choice between actively and passively managed TDFs. At the time the PPA was passed, there were very few passively managed TDFs, he says, but that has changed: “The marketplace has changed, and there is greater variety within passive off-the-shelf solutions.”

It may still be a small portion of the market, O’Meara says, but the firm has seen more interest in passively managed TDFs in recent years. “We think, at Towers Watson, that active management is a difficult task to accomplish in a single class,” he adds. “You need to be in the top 40% of investment mangers consistently over time to outperform the market. When you look across multiple mandates and multiple asset classes, very few have the skill set across all the classes and mandates to do this.” 

Easy Unbundling

The issue of this kind of ability is specific to TDFs, O’Meara feels, since many skilled managers can outperform in fixed income, for example, or in large-cap U.S. equities. But it is difficult for someone to outperform in each and every class.

These days, plan sponsors can much more easily move to separate or unbundled recordkeeping and investment duties, O’Meara says. “The ability is far greater than it was five, six or seven years ago,” he says. “Large-plan sponsors have a greater ability to use third-party investment mangers or even build custom solutions through further unbundling the components of the recordkeeper, the custody and asset management and portfolio construction.”

A custom approach provides the greatest opportunity for plan sponsors to provide the TDF best suited to their participants’ needs while managing the risks and outcomes specific to the needs of the plan, Towers Watson says. Organizations that cannot pursue custom TDFs (either because of a lack of time or expertise, or a lack of interest in unbundling responsibilities), should consider passive, off-the-shelf products, the paper contends.

A custom approach requires more governance, however, Towers Watson notes. “The DOL has become aware that not every plan sponsor is utilizing their flexibility and strength to negotiate with their vendors to ensure they are getting the best product or at least one they’ve done their due diligence on,” O’Meara says. “In general, we continue to see plan sponsors out there using the funds of their recordkeeper. If you look at the largest recordkeepers, they also happen to be the largest TDF managers.” But custom TDFs maximize fiduciary oversight by putting the oversight of the recordkeeper, custodian and asset manager in one place instead of having separate firms to do it all.

Some sponsors may want to give careful thought to passive implementation in an off-the-shelf product. “One drawback for off-the-shelf providers is that if they don’t have investment skill in a particular class, it probably won’t find its way into the product,” O’Meara says.

Off-the-shelf products simplify fiduciary oversight, O’Meara says. A single manager determines the glide path and typically invests the assets, instead of having separate firms do it all. Plan sponsors will need to choose between active and passively managed funds. Today, O’Meara says, passive funds offer a greater variety of goals and metrics.

Pinning down some of the processes in TDF selection is important. “How much governance are they willing to put into the process?” O’Meara says. If the plan sponsor is squeezed by time or resources, it may be better to separate the responsibility for these decisions, from underlying asset allocation to portfolio construction.

Determining governance capacity is an important task for the plan sponsor, Towers Watson says. That capability allows the plan sponsor to be available for overseeing the selection, implementation and monitoring of the TDF. Limited capacity can steer a plan sponsor toward an off-the-shelf product or to outsource the governance.

A link to download “Are You in the Wrong Target-Date Fund?” is here. 

Data & Research August 25, 2014

Researchers Propose Trusteed Retirement Funds

A new paper published by the Social Science Research Network recommends a single private defined contribution (DC) pension system that can cover all working Americans, with a single set of rules.
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A key part of the proposal is the creation of broadly diversified Trusteed Retirement Funds (TRFs), whose sponsors are trustees, with fiduciary responsibilities.

Payroll deduction of every employee’s salary would automatically go into a broadly diversified TRF unless the employee either opts out or selects a preferred TRF, or if the employer already sponsors a defined benefit (DB) pension plan. TRFs will relieve employers from fiduciary responsibility for all future DC contributions.

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To protect retirees from the risks of inflation, longevity, and the unpredictability of the stock and bond markets, retirees will be encouraged to use their TRF savings to buy either an immediate or deferred indexed annuity. A Federal Longevity Insurance Administration would be established to enable private insurance companies to provide cost-effective annuities.

All TRFs and annuities will be without marketing costs.

The paper’s authors, Russell L. Olson and Douglas W. Phillips from the University of Rochester, looked at other countries’ retirement systems when developing their proposal, giving special consideration to Australia based on the success of its superannuation program. This program mandates high pension contributions for every employee by his employer, but the contributions go to managed funds that each employee may select. The researchers note, “Australia now has the fifth highest ratio of pension assets to GDP (92%), and it has accomplished most of this in the last 20 years. Australians now have more money invested in managed funds per capita than any other economy.”

According to the paper, Australia has accomplished this through a wide range of private defined contribution funds called “superannuation funds,” which must meet specific requirements. To be tax-qualified, each fund must have a trustee, a trust deed defining members’ rights and obligations, a written investment strategy with broad diversification, and the most widely used funds must meet certain standards for fees and reporting.

The researchers said they do not believe Americans would agree to the mandating of large pension contributions in addition to what they already contribute to Social Security (through FICA taxes). But they believe the challenge of adequate retirement savings for Americans can be met by establishing high levels of retirement contributions by employees to Trusteed Retirement Funds, from which employees have the right to opt out, and by adapting the best of Australia’s superannuation concepts.

In the paper, the authors lay out the blueprint for TRFs, including fiduciary, governance and investment requirements. Those who believe they can invest their money better than any available TRF may set up their own TRF. In addition, sponsors of regular TRFs may offer options that allow participants to implement their own investment strategy and to invest in their own portfolio of mutual funds and other investments. The opportunity would offer many of the benefits of a self-managed TRF at a fraction of the cost, provided the portfolio met the sponsor’s fiduciary requirements.

The authors note that retirement plan participants do not often purchase annuities with their lump-sum distributions at retirement, and contend that retirees would benefit from an alternative that is not now widely available—a deferred annuity, which an individual would purchase when he retires and from which he would begin receiving payments if he lives to a much older age, say 90. The premium for a deferred annuity 25 years into the future would require only a small portion of the retiree’s retirement assets (perhaps as little as 3%), and then he could safely spend all of his remaining assets by the time he turns 90.

Unless the purchase of an annuity was mandated, however, why would most retirees be motivated to buy one? The authors suggest their motivation would be spurred by two provisions of their proposal:

  • A central accounting agency would get workers thinking in terms of annuities throughout their working career by including in each worker’s annual report: the annual amount of an indexed annuity that the worker’s current TRF balance could currently buy at age 67; the cost at age 67 of a deferred indexed annuity for that amount, effective at age 90; and the same information for a joint and survivor annuity. This information would be intended to show a worker how much more he needs to save in order to ensure an adequate income in retirement, and to get him thinking in terms of buying an annuity whenever he retires.
  • When a retiree requests his first withdrawal from a TRF (or any other remaining DC fund) the fund would purchase a deferred indexed annuity for him unless the retiree elected in writing any of the following options: buy an immediate indexed annuity; buy a deferred annuity starting at a different age, say 85 or 95 (based on an alternative pricing list); or buy no annuity. The premium for annuities would have to take into consideration the negative selection that would result from the fact that retirees who do not expect to live long would choose not to buy an annuity.

Regarding tax incentives for retirement savings, the authors said the government should redirect its retirement tax subsidies to best accomplish its purpose. They suggested starting with tax relief for workers earning, for example, $30,000 or less. To encourage them to make TRF contributions, their contributions should be treated as tax reductions instead of tax deductions.

In order to limit total tax subsidies for retirement funding to the current level of tax subsidies, current year eligibility for a person to make further TRF contributions would be denied to any participant whose market value of assets in his combined defined contribution accounts exceeds a maximum balance. The maximum balance should be whatever figure would maintain the nation’s total tax subsidies for retirement funding at the present level of its tax subsidies. The maximum balance would vary by the contributor’s age, allowing for the number of years that remain for investments to continue earning returns. “This approach would use our federal tax spending for retirement in a way that would encourage retirement savings by the maximum number of American workers,” the authors concluded.

More details about the proposal are in the paper “Let’s Save Retirement,” which may be downloaded from here.

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