Unbundled TDFs Attract Sponsor Attention

Retirement plan advisers can deliver significant value by helping sponsor clients address the shortcomings of prepackaged TDF solutions, says Tara Mashack-Behney of Conrad Siegel Investment Advisors.

Mashack-Behney is partner and president at Conrad Siegel. She says there is something of a contradiction at the heart of many prepackaged target-date fund (TDF) solutions. Prepackaged TDFs are often added to retirement plan menus as the qualified default investment alternative (QDIA)—as one of the prudent safe harbor investment options mentioned specifically in the Pension Protection Act of 2006. The products tend to have well-designed asset-allocation glide paths and are overseen by skilled portfolio managers benefiting from economies of scale and powerful analytics, Mashack-Behney explains, giving sponsors a sense of protection and paternalism behind the TDF.

While the advantages of prepackaged TDFs are generally understood by sponsors, most overlook an important potential drag on proprietary TDF performance, she says. The drag is this: Fund companies often install mandates limiting what underlying funds their TDF managers are allowed to purchase as part of the proprietary TDF portfolio. In many cases the managers are only permitted to invest in their own firm’s fund offerings, Mashack-Behney says, even when those funds consistently underperform similar offerings on the market.

“From the beginning of our work in target dates we started recognizing that pattern,” she tells PLANADVISER. “When you look at fund company X’s 2020 fund, for example, all of the underlying investments across the asset categories are likely to come from company X, regardless of whether the company offers a strong fund in a given category.”

Mashack-Behney says that more plan sponsor clients seem to be growing aware of this potential prudence problem. They still like the name recognition, strong governance and customer support behind the big proprietary products, she says, but sponsors are also becoming concerned about the implications of placing proprietary mandates on underlying TDF holdings. It’s not hard to see how the proprietary mandate could harm the fund manager’s ability to truly pursue the best risk-adjusted returns at the right expense, she says.

One answer to the proprietary mandate problem, Mashack-Behney says, is to build an “unbundled TDF” from the plan’s core menu. This will likely require collaboration with a skilled fee-only investment adviser who has the ability to create and adjust advanced model portfolios created from core menu options, she says, but the payoff can be substantial.

Some clients are also concerned about the idea of offering two different sets of funds to employees—one set on the core menu and another set for participants joining the plan under the QDIA provisions, who in effect are limited to funds offered by the TDF provider.

“We realized that we were putting all this consulting work into developing a sensible mix of 10 or 12 funds to offer as the core menu to the few people who wanted to build their own asset-allocation mixes,” Mashack-Behney explains. “But the participants being defaulted into the plan under fund company A’s TDF were basically not given any access to these funds and had to settle for company X’s lineup, some of which may be underperforming the options on the core menu. This is a problem.”

Jake Gilliam, a managing director and senior portfolio manager at Charles Schwab Investment Management, makes a similar argument.

“We commonly see target-date funds that are using underlying holdings in basically untested or underperforming proprietary funds, funds that wouldn’t pass muster to be included on the core investment menu as a stand-alone fund,” Gilliam tells PLANADVISER. The matter probably isn’t at the top of an auditor’s to-do list, but investment committees could be opening themselves up to liability if they do not take care to ensure the underlying funds in a TDF meet the standards of the investment policy statement (IPS).

“When we present this idea to sponsors the first thing we do is look at their core menu and optimize that,” she explains. “We ensure that there is a fund in all the prudent asset classes for the average participant and that the offering in each class is the best available for that particular plan and its demographics.”

Then her firm takes the core menu offerings and builds model portfolios—either as a series of TDFs with automatic glide paths or as a series of risk-based portfolios ranging from conservative to aggressive.

“Once we conduct risk assessments and figure out which model the participant fits in, those models are managed by us,” she says. “We select the underlying mixes and we do the automatic quarterly rebalances for the participants in the risk funds. So for the participant it’s very much a do-it-for me arrangement, like the proprietary TDFs.

“The big advantage over these types of funds is that we could both be set to retire in the same year, but you can afford to take more risk than I can because you have a lot of outside funds. Our models can account for this, but many proprietary TDFs cannot,” Mashack-Behney says. “And another appealing feature of the custom risk fund series is that we can set up triggers to automatically move the participant down through the lower risk levels as they age, so the custom risk funds can also function like the TDF, but with a little more control. We call this our Automatic Risk Reduction Program.”

Participants are given a lot of disclosure in this model, she adds, and because the unbundled TDF is built from the relatively small core menu it is often easier for sponsors and participants to understand.

“Especially with the help of an adviser, you can really control and understand the mixes underneath the TDFs and the risk-based funds,” Mashack-Behney says. “It gives the sponsor more flexibility. We’re used to developing new asset mixes and we know how to build these portfolios from the defined benefit world, so what we’re doing is applying the thinking for our defined contribution clients.”