Tempered Interest in Custom TDF Market Belies Big Opportunities

Experts say the typical off-the-shelf target-date fund (TDF) isn’t as diversified as what could be created under a custom implementation.

Art by James Yang

Retirement plan experts say some plan sponsors embrace the idea of custom target-date funds (TDFs) because their open architecture structures allow the fund manager to select best-in-class underlying funds, which can lead to better performance than off-the-shelf TDFs.

But even as the price of building custom TDFs falls and more plan sponsors are open to the idea, their popularity has not exactly exploded.

“Custom TDFs aren’t necessarily growing in popularity, but we continue to have discussions with clients about custom solutions,” says David O’Meara, a senior investment consultant with Willis Towers Watson who specializes in target-date funds. “The market isn’t moving all that fast. It takes time for plan sponsors to determine a new path forward.”

Sponsors’ primary interest, O’Meara says, is to “have access to diversified investments.” With off-the-shelf TDFs, he says, the TDF manager will determine the asset allocation and typically only select from proprietary fund offerings. That limits the opportunities for investments.

“By separating out the asset allocation, it enables the custom TDF to select best-in-class managers,” he explains. “We find that the typical TDF isn’t as diversified as what could be created under a custom implementation. That could potentially result in better outcomes. In fact, we saw elements of that in the first quarter of this year, when many custom TDFs declined only 10%, while the market was down 35%.”

Jake Tshudy, director of defined contribution (DC) investment strategies at SEI Institutional, agrees that custom TDFs “fare better on a risk-adjusted return basis.”

Mike Volo, senior partner at Cammack Retirement, says TIAA has created a “liquid version of a fixed annuity product that can be used as part of a custom target-date solution. The guaranteed return helps mitigate volatility.”

Custom TDFs can also be a good choice for sponsors that have a unique population, such as airline pilots, whose careers typically start later and end earlier than other professions, O’Meara says.

“Large companies that also have a defined benefit [DB] plan can leverage some of those investment manager relationships,” he adds. “They are already conducting due diligence manager reviews for the DB plan.”

As for how much custom TDFs cost, Amit Sinha, head of multi-asset design at Voya, says one custom TDF that his firm manages has costs that are comparable, if not lower, than off-the-shelf TDFs.

“It depends on the size of the plan,” Sinha says. “If it is large enough that the underlying funds can be acquired at a low cost, you will see comparable prices. But if a custom fund moves 5% to 10% of the portfolio to expensive alternatives, like private equity, then you will see an increase.”

Smaller plans are also looking at custom TDFs because plans have become larger since 401(k)s were created in 1981 and, with those greater assets, more plans can afford custom products, Tshudy says.

Bill Ryan, a partner and head of defined contribution solutions at Aon, says that once a plan amasses $500 million in TDF assets, then it most likely has enough assets to cost-effectively built a custom TDF.

As far as the recent lawsuits against custom TDFs challenging their performance, and whether they are dissuading some plan sponsors from turning to custom TDFs, Mike Swann, client portfolio manager on the defined contribution team at SEI Investments, says plan sponsors are broadly aware of the amount of litigation in the retirement plan space in general.

“I don’t think the custom TDF lawsuits are gaining any more attention,” he says. “But we actually think you can control litigation risk better with a custom TDF than with an off-the-shelf TDF, because it is built for the specifics of your population.”

And products are being created to help those who do want to get into custom TDFs. In August 2018, Lincoln Financial Group introduced its own custom TDFs, called YourPath.

“We created the ability for a participant to choose from three different glide paths—aggressive, moderate and conservative—to match their risk tolerance,” says Ralph Ferraro, senior vice president, retirement plan products and solutions at Lincoln Financial. “They can then also select an actively managed, passively managed or hybrid solution. The focus is on personalization. We have seen from our research that three in four employers have workers who are looking for benefits that can meet their individual needs.”