The Duty to Monitor

Jamie Bentley: While there are many tools and resources to help select a TDF, we have learned that many advisers, as they try to build scale and efficiencies in their practices, need tools and support to navigate the complexities of monitoring TDFs. As one of the larger DCIO managers, serving more than 75,000 plans (and the advisers and consultants that support them), we have uncovered some best practices around TDF monitoring, and have created a roadmap to help advisers navigate the complexities.

Advisers have streamlined their process for the selection of a QDIA, but once a manager is in place, many advisers have questions about the best way to put together a systematic, ongoing monitoring process. 

Bentley: The use of TDFs began in earnest following the passage of the Pension Protection Act of 2006.  The 2008 financial crisis was an eye-opening event for many of these early TDF investors. They saw unanticipated negative returns from their TDF managers, even on the conservative end of the glide path, and so they started to look at TDF structures with greater scrutiny.  In addition, we saw an influx of managers entering the TDF market who offered a variety of philosophies and glide paths. Almost 10 years since the crisis, TDF use has skyrocketed, requiring a well–defined, systematic monitoring process that goes beyond traditional performance measures.  Does the TDF still meet plan needs, address demographic shifts and reflect the latest industry innovations?

In 2013, the DOL released “Target Date Retirement Funds – Tips for ERISA Plan Fiduciaries.” It outlined best practices and fiduciary responsibilities for plan sponsors. Among them was the fiduciary duty to have a process for the periodic review of TDFs. So not only are advisers heeding the advice of the DOL, I think many also see this as a competitive advantage. They can get a step ahead of their competitors by developing a superior process and articulating it to potential clients.

Bentley: To keep it simple, we’ve created a roadmap that clearly defines four steps for effective TDF monitoring. 

Step 1 requires the development of a timeline–a systematic approach for when and how to review TDFs. For instance, on a quarterly basis, a high-level review of performance is appropriate. On an annual basis, a review of plan objectives, modifications in manager philosophy and changes in plan demographics or participant needs may be appropriate. Additionally, every three to five years, a formal QDIA evaluation process and/or search may be appropriate. Even if everything seems to be going well with the TDF manager, it makes for good due diligence. 

The second step entails defining the process itself. We suggest a two-part process for the annual review of TDFs,  including both plan demographics and investment due diligence. From a demographic perspective, have savings rates changed in your participant base? Has there been a change in the average income level since the last review? Has there been a significant increase in the number of retirees and have they been keeping their assets in the plan? These are just some of the aspects plan sponsors should assess to determine whether the plan’s needs have evolved over time.

From an investment due diligence perspective it will be important to evaluate whether the philosophy of your TDF manager has evolved since selection. Has the glide path asset allocation changed meaningfully? Are longevity, market and inflation risks being appropriately addressed? Has the manager experienced organizational, process or investment team changes?  These are some of the questions that can help determine whether the manager’s philosophy has changed. 

The third element is the actual benchmark, and this is where it gets pretty tricky in the target-date space. Benchmarking is critical in monitoring TDFs, yet it is a challenging exercise. In the target-date space, every glide path is unique; some de-risk less over time, others more over time. Some emphasize longevity risk, others market risk. The wide variety of TDF approaches makes them very difficult to benchmark. 

The fourth and final step requires sound documentation of the process for monitoring TDFs. From a fiduciary standpoint, the DOL says it is important to document the process.

Bentley: TDFs are not a simple, single-sleeve category like a large-cap equity fund, for example. The mix of assets in a TDF, as well as the shape of the glide path, will be quite different across the universe of target-date providers, making peer group comparisons difficult. When we asked advisers, “How are you approaching this? Which benchmarks are you using?” we were able to identify five different approaches to benchmarking. Our TDF monitoring roadmap spells out the rationale behind each of these approaches: 

The most common benchmark compares the performance of the TDF to its own strategic glide path. This approach allows an adviser to judge whether or not the manager is adding value above and beyond the glide path. 

A second approach focuses on risk-adjusted returns rather than absolute performance. Top adviser teams often focus on Sharpe and Sortino ratios.

A third approach focuses on performance of the underlying funds, or the building blocks of the glidepath, with a special emphasis on fixed income asset classes.  A consistent theme we heard from advisers centers on the critical nature of the fixed income portion of the glide path, because older participants generally have larger balances and represent the largest percentage of plan assets. These participants have less time to make up for negative return events. This makes fixed income components more critical than equity components in the glide path. 

The fourth approach establishes a custom benchmark. This is simply an adviser or consultant constructing something comparable to the glide path, and measuring performance and alpha drivers.  Additionally, the investment manager may create a custom benchmark for comparative purposes.

The fifth approach considers benchmarks of industry peer groups. This is the least complicated tactic but may be flawed due to the challenges described above. Even if one tries to segregate TDFs funds into aggressive, moderate or conservative buckets, philosophies and approaches still vary widely.

PIMCO has tools to help advisers think differently with respect to benchmarking. GlidePathAnalyzer is a tool that employs forward-looking benchmarking techniques to help assess the probability of meeting important plan goals such as income replacement, or cash flow needed in retirement.

Bentley: The protocol would be similar to assessing the core menu. The investment policy statement [IPS] helps determine issues that need further scrutiny or watch-list status; it dictates how much latitude to give to an underperforming manager. Ideally, the IPS should have general guidelines for when to put a fund on watch. For example, it could be a failure to meet performance standards for two or three consecutive quarters, or material changes to the glide path. But the language shouldn’t be so rigid that one is locked into a decision that closes the door to committee discretion and consideration. For example, a conservative target-date manager may have underperformed in a “risk-on” market but the committee still prefers the conservative approach. 

My final point is that PIMCO stands ready to help advisers with the challenging task of benchmarking—not only for the core lineup but TDFs as well. While many plan sponsors have a process for thorough monitoring of their core lineup, fewer have access to systematic tools for benchmarking TDFs, a more complex undertaking. We believe PIMCO’s Target-Date Monitoring Roadmap can be a valuable resource for advisers and their clients.