Choosing the Right TDF for Your Participants

Retirement plan sponsors may know the story well: Released decades ago as investment vehicles for retirement plan participants who want to step back from managing their investments, target-date funds (TDFs) have, since the passage of the Pension Protection Act (PPA) of 2006, won a sizable chunk of the defined contribution (DC) market.

According to the Investment Company Institute (ICI), mutual fund-based TDF assets reached a record high of $790 billion in the first quarter of 2016, with almost 68% of that credited to usage of TDFs in DC plans. These funds are the most popular qualified default investment alternative (QDIA), used by  72% of large- to mega-sized 401(k) plans, according to a recent study by asset-management and research firm AB. And there is an impressive and increasing diversity of TDF products, as Morningstar now tracks more than 51 different TDF series.

With so much ongoing development in the market, new products are emerging with designs that vary widely in terms of asset allocation; underlying fund selection process, which can be firm-specific or open-architecture; investment strategy, which can be active, passive or a mix of both; and glide path, which can either travel “to” or “through” a participant’s retirement.

“All these need to be considered against the plan’s overall objective and philosophy,” suggests Toni Brown, senior defined contribution specialist, Capital Group. She also notes TDF prospectuses, historical performance, and risk statistics are all crucial to review.

Like others, Brown suggests these factors need to be scrutinized even more in a rapidly changing regulatory environment with heightened retirement risks.

“As people are living longer, we need to do more to hedge against retirement capital being eroded by things like inflation,” agrees Tony Fiore, senior vice president and national sales manager of retirement investment solutions at Prudential Investments.

AB also notes that the industry is seeing innovations to meet these goals. The firm suggests some key areas where plan sponsors can evolve TDF design. First, it recommends considering a multi-managed or open-architecture approach to asset management with a diversified mix of underlining funds that utilizes well-tested stocks, bonds and non-traditional asset classes. It also points to adopting a dynamic rather than static approach that responds to short-term market fluctuations but also mixes passive strategies to enhance risk-adjusted returns and manage costs.

AB also recommends using a glide path that looks to enhance results in the distribution phase of a retirement plan, which it calls a “critical but often overlooked component of any retirement plan solution.”

NEXT: Other opinions on TDF design 

“There is a great change that needs to take place as participants reach retirement and then move into retirement,” says Brown. “The type of equity that’s being invested in, for example, and the type of fixed income that’s invested in needs to change … Downside protection becomes very important. Plan sponsors need to think about having a target-date series that understands that and can serve participants during the savings period as well as in the retirement period.”

Some may disagree, but one of the meaningful benefits to introducing elements of active management into the TDF is that it tends to protect more in declining markets. In other words, active management can serve people in distribution better because it protects better in declining markets—however, the impact of fees and manager performance are equally important to consider, potentially pushing the balance toward passive.

Fiore notes that combining an active investment approach with passive can generate alpha when possible while also addressing cost concerns in the portions of the portfolio where it makes sense to go passive. 

All the experts agree that plan sponsors can benefit from referencing different data and benchmarking services that more and more firms and investment consultants are offering to help plan sponsors evaluate TDFs. These include Morningstar’s proprietary rating system that gage TDFs on five criteria including people, performance and price. In addition, the Russel Target Date Metric was built to measure the ability of the TDF family to build wealth for retirement. The S&P Target Date Scorecard tracks analytics covering the entire TDF universe and separately tracks “to” and “through” glide paths. There are many other examples.

Of course, plan fiduciaries must also remember that different TDF strategies will serve each unique participant population differently, which is why exploring employee demographics is crucial to selecting a TDF line up.

NEXT: Studying Participants 

A recent TDF report by the National Association of Government Defined Contribution Administrators (NAGDCA), offered some solutions for deciding whether a TDF series best aligns to a participant population’s needs. These cover topics like how each age cohort is invested, targeted income replacement ratios, and integration with other benefits programs.

Another area that deserves special attention is education, especially considering that many studies have suggested participants are misusing TDFs. A recent survey by Voya Investment Management found that only 15% of respondents place 100% of their contributions into a single TDF. In an interview with PLANSPONSOR, Susan Viston, client portfolio manager with Voya’s multi-asset strategies and solutions team, suggested the firm’s research has also found participants to be invested in as many as 10 TDFs within a single line up.

Furthermore, the Voya survey highlighted some specific participant preferences when it comes to TDF design. It found that most participants prefer multi-manager TDFs with a mix of proprietary and non-proprietary funds that are active and passively managed. The want the best the markets have to offer, in other words.

“We see more and more participants really want to take advantage of the benefits of TDFs. It should become the driver of asset growth going forward. It really ends up becoming hands down the best option in DC,” says Brown.

AB’s “Designing The Future of Target-Date Funds” report can be found at abglobal.com.

The Target Date Funds guide by NAGDCA can be found at nagdca.org.

Voya’s “Participant Preferences in Target Date Funds: Fresh Insights” can be found at investments.voya.com.