Target Practice

To a plan sponsor, the Department of Labor (DOL)’s guidance on target-date funds (TDFs) may sound like Charlie Brown’s teacher: “Wah, wah,” jokes Jim Sampson, managing principal at Cornerstone Retirement Advisors LLC in Warwick, Rhode Island.

Although guidance is useful, plan sponsors often have trouble trying to make sense of it, which is where advisers can help, Sampson says. In March, the DOL issued general guidance to assist plan fiduciaries in selecting and monitoring target-date funds. The guidance makes several points, but of chief concern is the suggestion that plan fiduciaries inquire about whether a custom or nonproprietary target-date fund would be a better fit for their plan than a prepackaged TDF product.

As open architecture has gained traction in recent years, the target-date fund selection process has become more difficult because so many choices exist, Sampson says.

Monitoring the funds is also difficult because few resources are available to help with the process. Although many companies offer TDF-monitoring products, the industry lacks independent tools, he says.

Chris Rowlins, senior consultant at Fiduciary Investment Advisors in Windsor, Connecticut, says that in recent years, the number of offerings in the TDF space has increased significantly, including new off-the-shelf options as well as custom strategies. The presence of more glide paths in the marketplace has made ongoing monitoring increasingly difficult. Because glide paths vary so widely, benchmarking a target-date fund’s performance against its appropriate peer group is yet another challenge for the industry.

The DOL’s guidance is an example of its continued focus on target-date funds and highlights how difficult it will be for advisers who do not specialize in the defined contribution (DC) space to properly aid in the TDF selection process, says Mark Wetzel, president of Fiduciary Investment Advisors.

Is the Guidance Unrealistic?

Sampson says it is unrealistic to expect custom target-date options to be available with many providers, regardless of market size. “Most companies don’t have the capability to recordkeep a true custom model and don’t want to give up the revenue they receive by using their own funds,” he says.

The small-plan market—generally, plans with less than $10 million in assets—has limited options for target-date funds, he says. “In the small market, [recordkeepers] either only offer the house brand [TDF] or the house brand and another option that’s less appealing,” he explains. “This is one of the challenges I run into on a daily basis.”

But it is not just small plans that have yet to adopt custom target-date funds. According to research from PLANSPONSOR and Janus Capital, in 2012 only 24% of all plans and less than half (45%) of mega plans—i.e., defined contribution plans with $1 billion or more in assets—considered using custom TDFs. In reality, however, just 12% of all plans and 14% of mega plans have actually implemented them.

The DOL’s guidance also says nonproprietary target-date funds could offer advantages by diversifying participants’ exposure to one investment provider. Sampson says the small-plan market does have an advantage in that regard: House brands in the small market are “sub-advised,” using outside managers.

Ultimately, the plan fiduciary must have a prudent process that takes into account the relevant factors when deciding whether to offer a target-date fund and when selecting a particular fund, says Bradford Campbell, counsel at Drinker Biddle & Reath LLP’s Employee Benefits and Executive Compensation Practice Group in Washington, D.C.

In his view, Campbell says, proprietary vs. custom is no more or less important than any of the other factors considered in making a fiduciary decision, such as cost, glide path and “how a particular product suits the needs of a particular plan,” he says.

It is very unlikely that the DOL will require that custom target-date funds be used, says John Greves, portfolio manager at Russell Investments’ Seattle location. “It’s really just about including them as part of the evaluation process.”

Prudent Monitoring and Evaluation

Wetzel says the DOL’s tips are a reminder of the ongoing obligation of a fiduciary to evaluate a plan and determine what works best. The DOL also says fiduciaries should establish a process for comparing and selecting TDFs, as well as a periodic review of the selected funds.

In addition, the DOL suggests that fiduciaries:

• Understand the TDF’s investments and glide path. Become familiar with the allocation in different asset classes—stocks, bonds and cash—and individual investments, as well as how these will change over time.
• Review the fund’s fees and investment expenses. Target-date funds’ costs can vary significantly, both in the amount and types of fees.
• Develop effective employee communications. Have you planned for employees to receive appropriate information about target-date funds in general, about the funds as a retirement investment option and about the individual funds available in the plan?
• Take advantage of available sources of information. This is helpful for evaluating the fund and recommendations you receive regarding the TDF selection.
• Document the process. Plan fiduciaries should document the selection and review processes, including how they reach decisions about individual investment options.

At least once a year, the plan sponsor should review its target-date funds relative to marketplace offerings. Similar to the oversight of plans, these offerings change as new assets and approaches are added, Wetzel says.

Rowlins suggests plan sponsors choose the target-date fund most suitable for each organization, regardless of whether it has a proprietary flavor.

Off-the-shelf options allow small plans to commingle their assets, which drives down costs, Greves says. For the smallest plans, off-the-shelf will likely be the best option compared with custom TDFs, he says.

“Just be prudent,” says Rod Bare, defined contribution consultant at Russell Investments’ Chicago location. “Approach this [selection] the way a prudent expert would, and look at it from different angles.” Bare suggests that plan sponsors and their advisers ask the following when benchmarking target-date funds:

• Is the manner in which the target-date fund de-risks reasonably relevant to the types of participants who will use these solutions?
• Are the asset classes inside the fund diverse enough?
• Are the managers used in the fund “best in class?” Do they have a good track record?
• What are the fees like? Bare says to keep in mind that the lowest-cost TDF may not be the best.

Target-date funds are difficult to benchmark in the traditional sense because of glide path diversity, according to Morningstar. A white paper from the company, “Benchmarking Target Date Funds,” suggests TDF methodologies can be split into three key components, which can be evaluated separately. Each component can be scored independently to assess the quality of the fund, and an overall fund family rating can then be assembled to support adviser and plan sponsor due diligence efforts:

• Asset class diversity. This is the quality of the portfolio, relative to a desired risk profile, based on asset-class diversity and the allocation optimization process;
• Risk control. This methodology adjusts the asset allocation to synchronize the portfolio’s risk profile with that of the targeted investor risk profile over the investment horizon, commonly called the glide path; and
• Security selection. How a TDF invests to capture the essence of an asset class covers several areas, such as active vs. passive; direct investment or fund-of-funds structure; degree of intellectual capital diversity—e.g., if all the ideas and economic assumptions come from one fund family’s research department; and asset-class performance, net of fees.

With the help of their advisers, plan sponsors should evaluate the different TDF options offered by their recordkeepers in the overall context of plan design. If the plan sponsor believes that none of the available options is appropriate for its plan, it should consider all of its alternatives, including changing vendors, suggests Matt Kaminski, research associate at Fiduciary Investment Advisors in Windsor, Connecticut.

Greves agrees, saying it would not be outlandish for plan sponsors to switch recordkeepers, should theirs fail to offer robust target-date fund options. “This is a really important [investment] solution,” he says.

Challenges Remain

AS target-date funds (TDFs) become more popular, structural and communication challenges remain. When PLANSPONSOR and Janus Capital first began to track the funds’ usage in 2007, just 36% of defined contribution (DC) plans said they had this investment option in their lineups. In 2012, nearly three-quarters of all DC plans had at least one target-date fund family on their menu. A paper from Meketa Investment Group, “Target Date Funds: Structurally Unsound,” asserts that the current generation of TDFs has structural flaws, and plan sponsors and investors should avoid most—if not all—of these funds.

Target-date funds are expensive because of heavy reliance on active equity managers and therefore are priced—and behave—like actively managed equity funds, Marc Fandetti with Meketa Investment Group in Boston argues. Actively managed target-date funds probably cannot, on average, add alpha over time, he says.

“It is difficult for all but the most sophisticated plan sponsors and advisers to conduct rigorous enough performance attribution to truly get to the bottom of realized returns,” the Meketa paper says. “And if such analysis is beyond the capability of many plan sponsors, it is almost certainly not possible for the vast majority of plan participants. In this sense, TD funds are opaque.”

During the recession, target-date funds got a bad reputation because many investors lost a large percentage of their assets, says Chad Parks, CEO of The Online 401(k), based in San Francisco. During the height of their prerecession popularity, TDFs took more equity risk than normal in order to gain more returns and attract investors to their funds, but this blew up in the market downturn, he says. The recession taught plan sponsors that, if they have target-date funds in their lineup, they must understand the limitations and expectations of managers to follow a glide path. The funds are regaining popularity now, and Parks says the “TDF 2.0” can be a good thing if managed correctly.

Communication challenges about the funds’ structure also exist. If a sponsor polled its participants and asked whether their target-date fund was “to” or “through” retirement, the majority would be confused, says Brooks Mosley, president of Independent Pensions Solutions in Jackson, Mississippi.