Staying on Target

“What fund suite is in your plan, and why?” Many plan sponsors cannot answer that question about their target-date funds, says Jeb Graham, a partner and retirement plan consultant at Tampa, Florida-based CapTrust Advisors LLC. Sponsors need advisers’ help filling that big knowledge gap, he says, because if sponsors do not understand their target-date funds now, they may face legal problems as a fiduciary later. “It starts with a consultant’s job—to educate the plan sponsor on what kind of target-date funds they have picked,” agrees Attila Toth, a partner at Portfolio Evaluations Inc. in Warren, New Jersey.

Asked where advisers can add the most value to helping sponsors evaluate whether they have the right target-date funds in a plan, Graham says, “A lot of it is educating them to what they have and whether it is in line with what they think they have, versus what they want to have.” The investment policy statement of many plans is silent about criteria for selecting the target-date funds, he says. If that is the case, a sponsor first needs an adviser’s help defining the criteria; then, an adviser plays a crucial role in the ongoing monitoring of whether the funds consistently meet the criteria established.

When plan sponsors evaluate target-date funds, performance numbers tend to get the bulk of their attention, probably because of the relative ease of interpreting them, says Jeremy Stempien, director of investments at Morningstar Retirement Solutions. “I think that the most difficult aspect for them is knowing what to look at,” he says. “They need to look at it with a different lens than single-strategy funds. They are more-complex vehicles.”

Monitoring target-date funds is much more than simply comparing a fund to some index or benchmark, says Josh Cohen, Russell Investments’ defined contribution(DC) practice leader. “We have been moving as an industry, and we need to continue to move, beyond just a simple benchmark comparison and more toward performance attribution,” he says. “You need to understand what the real drivers are.”

Sponsors also need to understand their bottom-line goals for target-date funds. “In the past couple of years, we have seen more plan sponsors looking at this strategically—and from a broader benefits perspective—and making changes accordingly,” Graham says. An adviser can help the sponsor work toward answers to key questions like, “As a committee, what is your goal for the portfolios? What problem are you trying to solve?” he says. For instance, a couple of his sponsor clients have moved to target-date funds with a more conservative investment-strategy, partly so as to use these funds as automatic enrollment defaults.

Sources spoke about five key elements to monitor in evaluating whether a plan still has the right target-date funds.

1 Pegging the right risk level.  

Of course, advisers measure things like standard deviation and the Sharpe ratio. But start focusing more on the funds’ expected volatility, given their asset-class allocations, suggests Frank Salb, manager of investment services at Lockton Retirement Services in Kansas City, Missouri. “Measuring risk really comes down to all the asset classes they have exposure to, as opposed to just looking on a quantitative level at risk, in terms of how volatile it has been over the past one, three or five years,” he says.

Ultimately, Cohen says, keep in mind the main risk for the future—that participants will not meet their retirement-income goals. “What you can do is look at: How well does the target-date fund glide path tie to the specific objective you have for your participants?” he says. “If your participants have a required income-replacement need, is the glide path built to meet that? Or is it focused on a more capital-appreciation approach?”

An adviser can help a sponsor figure out how its goals for participants translate into the right equity composition and risk level in target-date funds. “Clearly, if a 2015 fund has 50% in equity, there is more market risk than for a 2015 fund that has 30% in equity. So the market risk is a concern,” Graham says. “But there is no right answer. It is an issue of understanding what participants need and making a decision accordingly.”

2 Watching for glide path shifts.  

Advisers should not assume that a target-date fund suite has the same glide path it did when originally selected. “We recommend doing a ‘deep dive’ to figure out how these things are built and how they compare with the rest of the industry, on a once-a-year basis,” Salb says. “Do the more normal performance monitoring on a quarterly basis.”

Some funds have a very well-thought-out methodology and stick to it, while others have shifted the level of aggressiveness over time, Stempien says. For instance, a fund provider may initially have a goal of investors achieving a 60% replacement ratio at retirement but, after research, starts targeting a 75% replacement ratio.

Cohen suggests several questions to ask target-date fund managers annually: Have they changed any aspects of the glide path in the past year? Are they considering changing any aspects in the next year, and, if so, why? Have they rethought their overall objective? And what is on their research agenda for the year to come?

Plan sponsors need to understand the influence such changes have and if any adjustments to the glide path conflict with the sponsors’ goals for the funds, says Sue Walton, a Chicago-based senior investment consultant at Towers Watson. For example, if a fund adds commodities for diversification, she says, “plan sponsors would want to reconfirm with the committee that they are comfortable with exposure to commodities as an asset.”

Advisers also can help sponsors grasp the nuances of the “to” versus “through” debate that has dominated much of the industry’s discussion of glide paths, Salb says. “That whole idea is an oversimplification. It’s important to look at the entire glide path, not just up to retirement. Some of the ‘to’ funds may be among the most aggressive in retirement.” A “to” fund gets more conservative perhaps 10 years before retirement. But “through” managers continue to decrease the equity in retirement, while “to” managers have stopped. So “to” managers can end up with higher equity allocations in retirement than some “through” managers, he says.

3 Scrutinizing underlying investments.  

Since target-date funds are fund-of-funds vehicles, sponsors also need help monitoring those underlying funds, Stempien says.

Many sponsors have difficulty with the enormity of that, says Kent Peterson, director of investment services at Securian Retirement. “They have a responsibility for evaluating each of those underlying managers, and, in many cases, target-date fund managers may combine 30 funds,” he says. That could exceed the number of core funds in a plan.

“For most of the packaged products, unless [plan sponsors] have an adviser doing that for them once a year, all they look at is whatever they get from their [provider’s] reports,” Graham says. Advisers who monitor underlying funds find there is no simple way to do it, like benchmarking a large-cap equity fund to the Russell 1000, he says. “Once a year, we benchmark all the underlying funds. Then we benchmark them against the Morningstar category average for that particular fund,” Graham says.

Monitoring underlying funds requires significant time and effort from advisers. “In our performance analysis, we look not only at what the fund as a whole has done, but we look at each of the underlying funds and evaluate them as if they were a core option in the plan,” Toth says.

4 Getting clarity on fees.  

Fee databases can provide good information for mutual funds, particularly retail ones, Cohen says. “For collective trusts, [the databases] are getting better. Where there is still a hole is with the custom funds. There is not really a good way today to do it. You can benchmark some of the components,” he says. Portfolio Evaluations has its own fee database, based on the experience of its clients and recent Requests For Proposals (RFPs) it has done.

Graham offers advice about how advisers can work with a provider to lower a plan’s target-date fund fees: “You frame that discussion within the same discussion of the overall revenue. What we do is push for the provider’s­ overall required revenue number. That is the magic number, not the underlying mutual fund fee,” he says. “If the plan assets grow by 30% and it is asset-based pricing, if the provider needed 40 basis points, that 40 basis points is now 40 basis points of a much larger number. We say, ‘What do you really need? Maybe that number should be 32 basis points.’” Lowering that number leads to lower fees for participants, he notes.

5 Understanding participants’ results.  

Delve more into how participants get out of the plan and whether they use a target-date fund as a distribution-phase investment. For instance, Portfolio Evaluations works with a plan that has many foreign-born employees. “When they retire, they take their money and go back home,” Toth says. “So a ‘through’ retirement fund would not make sense. Ninety percent of these individuals will not be [here], in the long run.”

Says Walton, “If participants at age 65 are getting out of the plan, is that something you should be thinking about, in terms of the glide path, post-65?”

Portfolio Evaluations created a proprietary tool to help sponsors determine whether they have the best target-date fund family to achieve participants’ best end results. It allows the adviser to project the retirement replacement ratio for different age groups in a plan, using a sample group and examining factors such as their salary, plan balance and deferral rate.

To get a sense of how different providers’ glide paths compare, Portfolio Evaluations’ tool has information from requests for information (RFIs) the adviser submits to target-fate fund managers. Then, as part of its analysis, it uses the data collected to forecast what the retirement replacement ration could be for different age groups in the plan, on different glide paths. “If they go through this process, it will not just tell sponsors what funds will give their participants the highest retirement replacement income,” Toth says. “It leads to conversations about, ‘What is the philosophy of the target-date funds? And does that blend with your goals?'”