When Considering Target-Date Funds, Evaluate Design and Impact

A new research paper suggests those considering the addition of target-date funds to a retirement plan need to consider the funds’ glide path and whether the offerings should be actively or passively managed.

The report, “Evaluating and Implementing Target Date Portfolios – Four Key Considerations,’ published by Vanguard Investment Counseling and Research, also asserts that plan fiduciaries need to ponder whether it is worth getting a customized fund built especially for their plan. Finally, say authors Michael Hess, John Ameriks, and Scott J. Donaldson, plan sponsors and administrators need to think about the potential impact on plan participation of adding or not adding a target-date option.

The Vanguard recommended considerations for plan sponsors include:

Asset allocation glide path – The chosen funds’ asset allocation shifts through time should match the investment committee’s view of the appropriate risk/return tradeoff for participants at each stage of life, as well as include exposure to asset classes the committee believes can add value. Sponsors need to discuss the glide path issue with their investment committee and evaluate the consequences of various levels of risk exposure through the glide path.

Passive versus active management – The costs and benefits of an index versus active approach should be carefully considered, keeping in mind expected performance, risks, and fiduciary responsibilities. Vanguard said plan sponsors who opt for active management should decide what combination of risk control and opportunity they want, how confident they are that a manager will outperform, and the degree to which they are willing and able to tolerate variability in returns relative to the benchmark.

Packaged or customized solution – The Vanguard researchers also contended that sponsors need to decide whether to arrange for a custom-designed target-date fund. Specifically, the sponsors need to be convinced that either the approach offers a significant expected performance advantage – net of costs – versus a packaged solution or that their participants differ both systematically and significantly from typical plan participants in such a way that a unique approach at a fund level adds value. “Of course,” the researchers said, “plan sponsors and their investment committees should believe strongly that they can, in fact, add value through customization.”

Affecting Adoption Rates

Vanguard also said sponsors should consider the impact on participant portfolios. Research shows that sponsor decisions play a critical role in influencing target-date fund adoption rates. Data also show that participants use target-date funds in a variety of ways, and that individual participant decisions through time drive the overall impact of target-date funds on plan asset allocations.

“By carefully examining these considerations, plan sponsors will likely make appropriate decisions when evaluating and implementing target-date funds for participants,” Vanguard concluded. “The implementation of target-date funds has a meaningful impact on participant portfolios, reducing the distribution of equity allocations while enhancing the age distribution of equity exposure. How quickly the effects take place will depend on how plan sponsors choose to introduce the funds.”

A 2007 Vanguard report discussed how the target-date offerings should be benchmarked (See Vanguard Proposes Benchmarking Approach for Target-Date Funds).

The latest Vanguard report is available here.