The Markets October 20, 2015

TDFs Start to Go Global

Plan sponsors need to understand the implications of how their plan’s TDFs may be affected by changing exposures to international stocks and bonds.
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Target-date funds (TDFs) have quickly become a favorite default option within retirement plans. While the overall split among stocks and bonds within a TDF series, the glide path, is a primary driver of results and therefore participant outcomes, what those asset classes are composed of can also impact results and is worthy of consideration, according to a white paper by Portfolio Evaluations Inc.

As a number of TDF providers have announced changes to their TDFs’ international stock and bond exposures, it is important for plan sponsors to understand the implications of those changes and how their plan’s TDFs may be affected, says Kathryn Spica, senior investment analyst at Portfolio Evaluations and author of the paper. TDF providers can also use different tools when implementing these changes, from strategic shifts to tactical overlays to currency hedging, adding another layer to consider when evaluating the product.

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Since 2007, the average international stock exposure across TDFs has moderately increased, from roughly 18% to 22% of assets. On the bond side, the average international exposure has grown, from less than 1% to 4% of assets

Those numbers are likely to grow further this year. For example, Vanguard, the largest mutual fund target-date provider by assets, said earlier this year it would increase its international stock stake to 40% of stock assets throughout 2015, up from 30%. In addition, after introducing international bonds to the portfolio for the first time in mid-2013, the firm is also boosting the international sleeve of its TDFs’ bond assets, from 20% to 30%. American Century, PIMCO, Prudential and Schwab are among other providers adding international bonds or increasing their international stock exposure.

NEXT: Rethinking global exposures in TDFs.

Providers are continuing to rethink the global exposures of their TDFs for several reasons. One is to reduce the home country bias in their portfolios. While no provider has gone so far as to match the global market’s roughly 50% U.S./50% international stock split and 40% U.S./60% international bond split, over time the average allocation in TDFs has inched closer to that of the global market portfolio. For some providers, the strength of the U.S. stock and bond markets over the past several years is reason to think international markets may provide better opportunities going forward.

Not all target-date providers have moved at the same pace, and there is still wide variation in the range of international exposures across TDFs. No provider eschews international stocks completely, although there are still a few that do not utilize international bonds, or at least do not include a dedicated international bond strategy. In addition to the range of international exposures among different providers, there is also variation along individual glide paths.

Some U.S. stock and U.S. bond funds, while typically considered to be part of the TDFs’ exposure to U.S. markets, can also include exposure to international securities. For example, the longer-dated funds in MFS’ TDF series have a strategic allocation of 28% to international stocks. In practice, the funds have a larger allocation to international stocks, as several of the underlying domestic stock funds have some exposure to international stocks as well.

NEXT: Currency fluctuations can be another risk factor.

While most of the increases in TDFs’ international stock and bond exposures are strategic in nature, reflecting providers’ desire to have more global exposure in their products, some providers also have the ability to tactically allocate to international securities.

Investing internationally carries an additional risk from exposure to currency fluctuations, and plan sponsors should be cognizant of how their provider handles this exposure. For the most part, this function is managed by the underlying managers of each individual stock or bond strategy. Most stock managers do not hedge all their international currency exposure, as research has shown currency hedging generally does not materially reduce volatility or increase returns over the long term for stocks. For international bond exposure, however, most providers do hedge all or the majority of the currency exposure.

While the overall asset allocation of TDFs will continue to have the largest impact on results, it is important for plan sponsors to understand and be comfortable with the nuances of the sub-asset-class exposures within their selected TDFs.

As TDF providers in general take a more global stance, an evaluation of the international allocations and implementation tools used by TDF providers continues to be an important part of a prudent due diligence process.

“The Global Tilt in Target Date Funds” can be accessed through Portfolio Evaluation’s website.

Compliance October 19, 2015

Perez Speech Hints at DOL Fiduciary Flexibility

Speaking at a Brookings Institution public meeting, U.S. Secretary of Labor Thomas Perez said he is “confident we will be making changes to improve and clarify our proposal.”
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There is very little doubt remaining that the Department of Labor will stand firm on issuing a revised fiduciary rule under the Employee Retirement Income Security Act (ERISA), but comments made late last week by Labor Secretary Thomas Perez suggest additional revisions to the controversial proposal are still possible—even likely.

Perez started his address by noting “we’re in the middle of a huge shift in the retirement paradigm … to quote the learned philosopher Bob Dylan, ‘the times they are a changin’.”

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“Quite simply, this isn’t your father’s or your mother’s retirement,” Perez said, citing the common theme that Americans can no longer expect to work 40 years at the same company before retiring with a generous, or at least adequate, lifetime pension benefit. In the new environment dominated by defined contribution (DC) plans and a widespread lack of benefits coverage for many private sector workers, Perez said he firmly believes Americans now more than ever “need retirement advice they can trust. They need to work with someone whom they know is acting in their best interest.”

He warned that, without a best interest standard, it is too easy for advisers to benefit from indirect payments and hidden fees. “It’s too easy for working families to be unwittingly victimized by the corrosive power of fine print,” Perez said. “I don’t want to take too much time today, but I could share heartbreaking stories of families that saw their nest egg vanish because they put their faith in an adviser who may have given ‘suitable’ advice, but who wasn’t pursuing their best interest.”

Despite the tough-cop tone, Perez later said he does not want the fiduciary rulemaking to follow “a white hat-black hat narrative.”

“To be sure,” Perez said, “there are a few rogue actors out there. But this isn’t about bad people doing bad things; it’s about good people operating under a structurally flawed system where the incentives of the adviser are not properly aligned with the best interests of the customer.”

NEXT: Concrete changes in proposal still possible 

Perez said the financial advisory industry has been unwilling, for the most part, to admit it is in need of stricter policing.

“When we started doing our outreach as we were developing the proposed rule, some stakeholders' initial reaction could be summarized as, ‘Problem, what problem?’” Perez explained. “The status quo is working just fine, they said. But as our conversations evolved, I am heartened that there was a gradual but growing recognition among many about the importance of an enforceable best interest standard.”

Perez added that some industry practitioners have said that they support such a standard in principle, but that operationally speaking it will be too difficult to implement.

“But the fact is that a substantial segment of the market has already found a way to abide by it and do quite well for themselves,” Perez said. “We've heard and understand these concerns about logistical challenges during the comment period, and we remain flexible on the question of how best to make this work. We want to set parameters, not suffocate industry. The objective here is to provide guardrails, not a straitjacket.”

Perez said the Department of Labor (DOL) knows “there is no one-size-fits-all template here. We believe there should be flexibility for industry to discern the best way, given the unique attributes of their business, to implement a best interest standard while staying toward the center of the road, safely between those guardrails.”

That's why the proposal includes various carve-outs and exemptions, he said, to give industry that flexibility. “Flexibility is also baked into the cake of the proposed best interest contract exemption, which is designed to accommodate existing business models while still protecting consumers,” he added.

NEXT: Think more time is needed? 

“When people said that they needed more time to review the proposal, we listened again and extended the comment period by a few weeks,” Perez said. “I testified in June before a House Education and Workforce subcommittee and in July before a Senate HELP subcommittee. In August, the Labor Department reopened the comment period and hosted four days of public hearings, where we opened the floor to an array of perspectives.”

The second comment period remained open until September 24, giving everyone plenty of time to review the transcripts from those hearings. According to Perez, “this is one of the longest comment periods of any rule I have been involved with,” almost six months on top of at least 18 months of informal outreach. “All told, the number of comments and petitions received on the rule and its exemptions comes to 391,621,” he said.

Perez said the DOL will now focus on “spending the months ahead evaluating all the comments and giving them full consideration. There have been many constructive suggestions for improvements. Among many other things, we've heard concerns about potential burdens associated with the point-of-sale disclosure, data retention and the mechanics of implementing the best interest standard.

“I can't say right now exactly what the outcome will look like on these issues or any other comments and suggestions we have received,” Perez continued. “But I am confident that we will be making changes to improve and clarify our proposal, addressing legitimate concerns that have been brought to our attention. That is what notice and comment rulemaking is all about.”

A full transcript of Perez’s commentary, delivered October 16, is here.

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