TDF Customization Adds Considerable Complexity

A white paper from J.P. Morgan suggests custom target-date strategies can add real value to retirement plans, but the complexity of customization can quickly overwhelm the upside.

Penned by Daniel Oldroyd, head of target-date strategies and multi-asset solutions for J.P. Morgan Asset Management, the report warns plan sponsors and financial advisers not to shoulder more than they can carry when implementing a custom target-date fund (TDF) series. Especially in the small plan market segment, the significant resources and expertise needed to effectively manage custom investment options can seriously strain plan fiduciaries.

“Plan sponsors and advisers need to balance the benefits that custom strategies might offer with the required expertise, time and costs,” Oldroyd explains, “which can be significant.”

The report finds the word “custom” is loosely used to describe a wide range of offerings, but the general pros and cons of customization are clear. Perhaps the most important benefit, custom strategies allow sponsors to create TDFs that account for their unique employee demographics in building out the asset allocation glide path. For example, if a plan sponsor has a very generous match or a profit sharing component complementing the standard 401(k) account, the plan sponsor could implement a glide path that takes this into account.

Oldroyd says another common reason to go custom arises when a plan population has a mandatory retirement date that is earlier than the “normal” age range of 65 or 67. This population could benefit from a glide path that is somewhat more aggressive than the standard proprietary option, which will be tailored to fit the generalized investing needs of much larger groups of investors.

NEXT: Custom challenges

As Oldroyd explains, target-date funds are complex pieces of financial machinery with myriad moving parts. The three components used in constructing any target-date strategy include the glide path and asset allocation; the manager selection; and the implementation, including cash flow management and tactical asset allocation.

“In an off-the-shelf target-date strategy, an asset manager oversees all three components,” Oldroyd says. “But, in a custom strategy, the components can be disaggregated. When this occurs, there must be complete clarity about the roles and responsibilities of the plan sponsor, the glide path manager, the asset manager, and the party responsible for implementation—usually the recordkeeper or the custodian of the plan.”

Much of the busy work can be outsourced to a consultant or adviser, but this may prove to be prohibitively expensive for smaller plans, Oldroyd warns. And even when professional help is brought in, a sponsor using custom funds must be absolutely vigilant that all the moving pieces are turning together.

“Whenever a plan sponsor adopts a target-date strategy, whether it is off-the-shelf or custom, it constitutes a fiduciary act,” Oldroyd continues. “The plan sponsor’s fiduciary obligation is in no way diminished, whether the choice is custom or off-the-shelf. A plan sponsor must always act prudently in the selection and monitoring of plan asset investment options.”

Because of this, effective communications are critical when implementing a custom strategy. “While participants in an off-the-shelf target date strategy can access relevant information about their strategy’s funds on fund company websites, participants in a custom strategy may have only one source of information about their retirement funds,” Oldroyd says, “the communications they receive from their plan sponsor.”

NEXT: Building steam, but slowly

According to Cerulli Associates’ Retirement Markets 2014, target-date funds accounted for 13% of all defined contribution plan assets and 38% of contributions heading into 2014. Cerulli projects that those percentages will rise to 34% and 88%, respectively, by 2019.

While overall TDF growth is quite strong, Cerulli finds that less than 10% of all TDF assets are currently in custom offerings. This is due in large part to the complexity constraints outlined in the J.P. Morgan white paper. Oldroyd says customization has been somewhat concentrated among plans with $500 million or more in assets—generally because these plans have greater internal resources and expertise to take on the added complexity of customization.

“Often, plan sponsors lean toward a custom target-date strategy over an off-the-shelf offering because they think a tailor-made approach would better address specific characteristics of their plan, such as the demographic profile of their participants,” Oldroyd concludes. “But even after they identify those specific participant profiles, plan sponsors may be able to find an off-the-shelf target-date strategy that can accommodate them.”

The key, as in so many other areas of retirement plan design, is to devise, follow and document a reasonable assessment process that factors in both the price and value delivered through customization. Some plans will find customization makes sense, while others will not. In either case, backing up the decision with clear documentation is paramount.

The full paper, including a helpful assessment for plan sponsors to rate the potential utility of going custom, is available for download here.