A Calculated Risk
Not every plan sponsor has joined the rush toward target-date funds as a default investment. Among the new plans that MBM Advisors, Inc., has taken on during the past year, three-quarters still choose risk-based funds as the default, CIO Robert Burnam says.
Houston-based MBM’s clients include many professional-services groups with affluent employees. “Age has less to do with their risk tolerance, given the wealth of our clients,” Burnam says. “When they understand the glide paths of a lot of target-date funds, some plan sponsors are uncomfortable with how conservative those funds get: up to 75% bonds.” So, MBM builds those plans risk-based funds out of their core investment lineups. “The glide path is different in that you may or may not dial the risk down at age 65,” he says. “A lot of our [clients’] participants still look to be in a growth strategy.”
Despite all the target-date fund hype, risk-based funds remain common in 401(k) plans and, according to PLANSPONSOR’s 2007 Defined Contribution Survey, they continue to be commonly recommended by retirement plan advisers to their plan sponsor clients. Of employers that work with advisers, 24.8% offer risk-based funds as an option, compared with one-fifth (20.6%) of plans without. That rates second in option popularity, behind only target-date funds at 35.3%.
Risk-based funds also could get some pickup as a default investment among employers automatically enrolling participants in the wake of the Pension Protection Act (PPA). The qualified default investment alternative (QDIA) regulations issued by the U.S. Department of Labor in October did not specifically endorse risk-based funds as allowable defaults, but did permit the use of balanced funds or models, says Jim Geld, Managing Principal of adviser firm Retirement Targets, Inc., in Boca Raton, Florida. Therefore, industry consensus seems to be that risk-based funds—at least those with a moderate allocation such as 60% equity and 40% fixed income—work as a default, as long as employee demographics are considered, as required by the QDIA regulations (see “Default Vault“).
However, the QDIA regs did not tell advisers and sponsors how to gauge default investments such as risk-based funds. “Once we get past all the changes with PPA, our biggest challenge with this is, how do we create benchmarks?” says Greg Gaynier, Principal at Austin, Texas-based Retirement Plan Solutions, LLC, a National Retirement Partners member firm.
“Life Throws a Lot of Things at You”
Risk-based funds work well for participants who already have a good sense of their investing preference. Yet, they also allow advisers a better opportunity than target-date funds to work with individual participants who need help on an investment strategy, Gaynier says. For instance, he finds these funds more helpful for employees in their 50s who have not saved much for retirement and need to play catch-up with a more aggressive portfolio than is offered by a typical target-date fund for their retirement age. “During a downturn, they can move one step more conservative with their existing balance [to protect principal], and then move their new contributions one step more aggressive, the idea being to buy low much more of that aggressive fund,” he says. “Life throws a lot of things at you, and the gigantic flaw of the march toward target-date funds is that they do not handle that type of situation well. Target-risk fund investing can be shaped easier to fit that scenario.”
Risk-based funds make a better default than the current generation of target-date funds, Geld believes. “Target-date funds are treating everyone exactly the same,” he says. “They are developing them for the masses, and no individual is a mass. With risk-based funds, if you have an aggressive investor, he or she can make the switch into that type of fund.”
Best of Both Worlds
Some employers utilize both risk-based funds and target-date funds in their plans. The classic case comes when a plan previously offered a target-risk fund as an option, and decides to implement automatic enrollment and use target-date funds as the default.
“[Trustees usually] do not want to close out an option for their employees,” Geld says.
Deciding whether to keep both fund types in a plan involves evaluating the participant base and how well its members utilize the existing funds, says Scott Donaldson, a Senior Investment Analyst at Vanguard Investment Strategy Group. In some companies, because of concerns about complexity and participant confusion, employers choose one fund type or the other, but a plan can have room for both, he says. “The problem is, the education has to be stepped up a bit, to tell participants the differences between the two kinds of funds and what might be an appropriate vehicle for one participant versus another,” he adds.
Whether it does participants a disservice to offer both target-date and target-risk funds boils down to the communications at enrollment meetings, says Steven Medina, a Senior Vice President at John Hancock Financial Services. If both options get explained clearly and participants are shown a simple path to help them understand which is right for them, he says, they only have to choose between two types of investments—a big improvement over picking among 15 or 20 core mutual funds and then determining the proper allocation.
Six Things You Can Do
Although the industry lacks a universally accepted approach to benchmarking risk-based funds, Burnam says, there are widely used mechanics to gauge these investments—more so than with target-date funds, whose benchmarking tools are still relatively new. Because they do not have glide paths like target-date funds, they have fewer moving parts. “It does not mean that there are not assets moving, but it is all within the realm of a fairly constant asset allocation,” Donaldson says. “So, you can come up with a more-reasonable benchmark.”
Sources most often point to these steps:
1.Benchmark the underlying funds. This is a standard step, but a key one. “We are benchmarking every holding, in and of itself,” says adviser Scott Everhart, President of Dublin, Ohio-based Everhart Financial Group, Inc., which builds custom risk-based funds from plans’ core fund lineups, as an overlay to the current plan lineup. “If we are very comfortable with the core lineup, we know that the models will be extremely strong.” For off-the-shelf risk-based funds, he says, a breakdown of the underlying funds is generally available. Keep a particularly close eye on whether off-the-shelf target-risk funds include any poorly performing proprietary funds, he advises.
2. Create customized indexes. This approach involves mapping passive benchmarks to build a portfolio of indexes that best align with each risk-based fund. “All benchmarks for risk-based funds are customized, because they are different,” Geld says. For example, an adviser benchmarking an aggressive risk-based fund invested 100% in equities might create a blended index made up of 40% S&P 500, 30% S&P 400, 20% Russell 2000, and 10% MSCI EAFE foreign-stock index.
MBM Advisors creates customized indexes for five risk-based categories: conservative (20% equity/80% fixed income), moderate (40%/60%), balanced (60%/40%), growth (80% to 99% equity), and aggressive (100% equity). “We build blended indexes internally, and we have a database to do that,” Burnam says. “Smaller advisers may have difficulty doing that, because they are not cheap databases to buy.” MBM buys databases from, among others, HedgeFund.net, Lipper, Morningstar, Inc., Standard & Poor’s, and Zacks Investment Research. Broker/dealers might provide this data, he adds.
With its Lifestyle Growth Portfolio that has an 80% equity and 20% fixed-income allocation, John Hancock uses as its benchmark a weighted index of 80% S&P 500 and 20% Lehman Aggregate Bond Index. “Some people might say that is a little simplistic,” Medina says, but he thinks it meshes well with investors’ yardsticks. “Do participants think, “What did my international small-cap index do today?” No. They turn on CNBC to see what the S&P 500 did.”
3. Utilize peer universes. Suppose a plan has open architecture and a choice of a half-dozen risk-based fund families available, Gaynier says. “You have to do some sort of universe comparison to compare the funds individually,” he says. Index providers like Morningstar offer peer universes to do that but advisers need to look closely at the parameters of the universe because providers may group some funds in the wrong categories, Gaynier cautions. Fund companies may label funds with similar risk levels differently, or similar named funds may have varying underlying equity levels. Comparing an aggressive fund with 100% in equities to one with 80% in equities does not help, Burnam says.
“Most of the tools are designed to put funds in a box, and that may not be a fair analysis if you have a wide variety of securities in different asset classes,” Gaynier says. “In any peer-group category, you will have some funds that are a perfect fit and some that are not,” says Medina.
4. Do a fee comparison. Geld gets fee information from Morningstar and from fund companies’ Web sites. Risk-based funds often run between 110 basis points and 140 basis points for an A share, he says. A conservative fund typically carries the lowest cost, while an aggressive fund has the highest, partly because of trading costs and partly because equity-focused funds typically are more expensive than fixed-income funds.
Gauge these funds’ costs versus the portfolios’ average, Gaynier recommends. “Suppose that the average expense of my plan’s fund portfolio is 98 basis points,” he says. “If my target-risk funds are at 130 basis points, I have got a major problem with them. If the average is 108, I can live with that.” Referring to providers’ target-risk funds, he adds, “I believe 0.30% is too much to pay for the asset allocation; 0.10% to 0.15% is about right in the marketplace currently.”
5. Pinpoint the risk actually taken. When he considers these funds’ risk, Everhart looks at the return and standard deviation. “If that risk-return relationship of long-term growth versus moderate versus conservative is the way it is supposed to be, we are comfortable,” he says. Moving down the spectrum from aggressive to conservative funds, the standard deviation should decrease, he says, and, when selecting funds, he looks for managers who have done a good job controlling standard deviation. However, the industry does not have a rule for how much standard deviation should differ for an aggressive versus a moderate fund, for instance. It remains “just a feel” for advisers, he says.
Gaynier does not like to use standard deviation as a measure of these funds, however. “You need it on the upside because that is what gives you a positive return, but you want to limit it on the downside,” he says. “I prefer to look at risk in terms of up and down capture: what percentage of an up market a fund captured versus what percentage of a down market.” Using this analysis, he says, a plan is more likely to select funds that will not scare off the least-sophisticated participants in a downturn.
6. Examine asset allocations. Certain fund families want the market to accept that a particular fund can move across two or three style categories within a few years’ time, and still belong in the mix, Gaynier says. The “ugly secret” is that, in a fund-of-funds strategy within a target-risk-based fund, he says, “there are typically one or two funds that are off where they should be.” The drifting fund or funds should be removed from the portfolio for style drift or style inconsistency, which may affect the overall asset allocation and portfolio volatility, he says. “However, because the fund is an “all star” in their distribution system, they leave it in the target-risk portfolio because of its brand name rather than its investment-style consistency, or performance within the original style category.”
So, advisers need to make sure that these funds have stuck to their asset-allocation philosophies. The qualitative analysis probably rates as the most important thing an adviser can do to benchmark these investments, Burnam says, because “at the end of the day, participants are buying an asset-allocation decision.” So, he and his colleagues spend much of their time talking to fund managers about their fundamental beliefs on asset allocation.
“When you plot performance graphically as opposed to looking at pure statistics, you often see anomalies where funds have drifted,” Gaynier says. “When you have an anomaly, you have to investigate. Look at what the manager says happened, and look at what the statistics say happened.”
*Illustration by Leif Parsons