Many plan sponsors believe that offering a lineup of target-date funds (TDFs) is imperative, particularly for participants who are not utilizing personalized advice but still want and need a professionally managed solution for their assets.
But TDF offerings are by no means all alike. TDFs are typically offered by asset managers, banks, trust companies, and insurance companies in the form of mutual funds or collective trusts. Mutual funds or collective trusts may utilize either proprietary-only or open architecture investment strategies. Most TDFs rely on proprietary-only strategies. This means that asset allocation, manager selection, and security selection are all provided by the same firm. As a result, these funds are filled exclusively with proprietary investment choices.
Open-architecture funds are distinctly different. Depending upon whether the TDF is a “fund of funds” or a collective trust, the fund may search for and select non-proprietary funds or third-party managers to act as sub-advisers to the fund. Plan sponsors would do well to consider the key differences between proprietary-only and open-architecture target date funds. When it comes to flexibility, cost, aligned interests and track record, the benefits of open-architecture target date solutions are hard to ignore.
Since open-architecture TDFs are not wedded to a single firm’s underlying strategies, they can include a mix of different investing styles and seek out leading managers with the goal of delivering increased levels of diversification.
Frankly, it is unreasonable to expect any single firm to offer the best funds with demonstrated track records in every asset category, because every investment firm has its strengths and weaknesses. Open-architecture funds have the freedom to bring top funds or sub-advisers together under one umbrella, regardless of their “house brand” affiliation. This means an open-architecture fund could include large cap, multi-sector fixed income, emerging markets and small cap strategies, all from different managers that are considered among the best in class in their respective strategies, and better diversify the TDF relative to proprietary-only target date funds.
The use of third party sub-advisers means open-architecture TDFs are less vulnerable to groupthink. With proprietary-only strategies, all of the fund managers are typically relying on the same research, analysts, and economic outlook to form their point of view, which can be risky. TDFs that work with a number of firms help to mitigate this risk for plan participants because these funds have the benefit of a broad range of research, processes and schools of thought about the markets.
Though it might seem counterintuitive, some open-architecture funds, particularly collective trust funds, have an additional ability to control costs since they have the flexibility not only to search for a wide variety of strategies, but also to negotiate on price in a competitive search process.
Proprietary-only strategies may be restricted to their own underlying strategies, and by extension, the fees or expenses associated with those strategies. This can drive up costs, particularly for smaller or more specialized asset managers that lack the bandwidth to support a TDF for the defined contribution plan market. These costs can translate into higher operating expenses being passed on to plan sponsors and participants.
In an open-architecture lineup, the fund sponsor typically has negotiated pricing with its sub-advisers, and these savings can be passed on to the participants. With open-architecture funds, plan sponsors and their participants get access to investment managers selected based on portfolio fit, performance and pricing criteria; and specialist sub-advisers get access to the very large defined contribution market that may otherwise be out of reach. It’s a win for everyone.
Most plan fiduciaries would never consider constructing an all-proprietary core investment menu as part of their plan. Today, a typical mid-size defined contribution plan may offer 10 to 12 mutual funds from several providers. Essentially, that’s open-architecture, and it has been adopted because plan sponsors recognize that a diversified offering can help better serve participants.
Open-architecture TDFs are constructed using a similar approach. Unlike funds that are limited to using only proprietary products, open-architecture TDFs can select from an unconstrained universe of strategies, and make adjustments as warranted. This helps mitigate the potential for conflicts of interest to factor into decision-making, and provides better diversification.
Open-architecture target date funds can define the criteria for the type of third party fund or sub-adviser they want, and therefore focus on identifying managers and funds with demonstrated expertise. Proprietary TDFs are limited to offering what’s on their shelf, so while they may be able to offer a product to fill a particular slot, it can be harder for them to demonstrate their process for selecting the best funds for plan participants.
The Case for Open-Architecture
The idea of a one-stop, proprietary TDF line up may appeal to some, but the reality is that an open-architecture model offers a level of flexibility and transparency that cannot be dismissed. Plan sponsors need to apply the same level of rigor, due diligence and fiduciary process to their target date family selection as they do when putting together their retirement plan’s core offerings.
Asking the Right Questions
As part of the ongoing evaluation of the plan’s investment offerings, plan sponsors can start a dialogue with TDF providers by asking the following:
- How many different investment managers are represented in the underlying funds?
- If the underlying funds are all from one firm, do they use centralized research and economic forecasting?
- Are the underlying funds all active, all passive, or both?
- How much overlap is there among holdings in the underlying funds?
- What is the TDF manager’s process for selecting and removing the underlying funds?
- Are the underlying funds owned by mainly institutional or retail investors?
- Are the lowest-cost share classes being used for each underlying fund?
- What is the portfolio management tenure of the underlying strategies?
- Has the TDF provider ever replaced an underlying strategy?
- How well have the underlying strategies performed?
NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author(s) do not necessarily reflect the stance of Asset International or its affiliates.