Unbundling the Target-Date Fund

These are usually offered in the form of mutual funds or collective trust funds and are available almost universally across most open architecture platform providers. Large market plans have generally moved towards the custom target-date strategies which usually combine some sort of a model portfolio with a custom “glide path” bolted on to reflect the demographics of the participant base. This custom model “unbundles” the packaged target strategies and thus the pseudonym “custom.” In the mid-market space, we are left to choose from the fifty plus (and counting) mutual fund flavors what the most appropriate one is for our plan demographics. Let’s unbundle these strategies to identify the perfect target-date fund for your plan.

Glide Path

The first and probably most important component of a target-date fund is the glide path. This is the lifecycle that these funds bring participants through that adjusts risk according to the target retirement date. A target 2040 fund for instance would be relatively highly concentrated in equities since the participant presumably has many years and market cycles left, and can accept the volatility that many of these strategies will have.

Conversely, the target 2015 funds have dialed down the risk in the portfolio to a very modest level and these funds today have shifted mostly to conservative investments….or have they?

Different asset managers have different philosophies on this and you will find that the variability of equity risk varies greatly in this regard. For example, the T. Rowe Price Target 2015 currently has 55.8% of its assets in equities whereas the Wells Fargo Target 2015 has 25.6% (as of 6/30/2014). This could potentially explain the performance difference in the two funds considering that the T. Rowe Price 2015 strategy is highly concentrated in equity risk. This has proven a tremendous tailwind for performance and shareholders have been adequately rewarded for this risk. But is it appropriate?

This is where the waters get murky. When evaluating two mutual funds of traditional asset-classes, it is easy to look at risk-adjusted performance as the basis for comparing investment management. They are, in-fact, playing in the same sand box and so you can reasonably assume that measures such as Sharpe Ratio or the like will tell a relatively accurate story.

With target-date funds, this is not the case. In-fact, there is a generally accepted principle in investment management that there is an “equity-premium” over bonds when comparing risk-adjusted returns over long periods of time. So by definition, highly concentrated equity target-date strategies get a comparative advantage because of this inherent risk-adjusted premium that they receive. So Sharpe Ratio as a measure cannot be a reasonable evaluation tool for target-date comparisons.

The only reasonable conclusion to this digression is that the committee and consultant have to agree on an acceptable level of risk for a participant who is three years from retirement, and use that as the starting point.

Asset Management

In the mid-market, asset management gets swept under the rug throughout the course of evaluation. This is easy to explain, however. In well-diversified investment portfolios, 92% of the portfolio return is going to be determined by the asset allocation mix and not the attribution of active management in the portfolio.

So then this profound revelation highlights two important aspects of evaluation.

1) Fees- If most of the performance is determined by asset allocation and not asset selection, then this puts a big bulls-eye on fees. Why embed heavy active-management costs if this has little to do with outcomes of the participant?

2) Flexibility- Many off-the-shelf target-date funds are “fund of funds” strategies that will be limited to their own asset management when creating these investments.

During a due diligence meeting with a well-known target-date provider, I asked the portfolio manager what would happen if the mid-cap growth manager, who was in the target-date fund, lost his marbles and was no longer a suitable steward of capital. The blank stare I got back was quickly followed by a confirmation that this never has happened...but no answer was ever given.

This is not to pick on fund of funds providers, but a consideration should be paid to ones that incorporate proprietary asset management (they all do) and have the flexibility to use exchange-traded funds (ETFs), derivatives or other ways to gain inexpensive exposure to areas where active management cannot add value.

Guaranteed Income

This is a somewhat limited topic as this is not widely available throughout the mid-market, although there are strides being made to change that soon. This will be the third component—“defined-benefitizing” the defined contribution plan. This allows the participant to create an income stream to close the loop of what a target-date fund is meant to accomplish—to give a participant an opportunity to accidentally make the right decision—and allows the participant to focus on saving and not investing.

These guaranteed income products come in many different shapes and sizes but the concept remains the same: allowing the participant access to an institutionally priced annuity contracts that “bolt on” to the target-date investment product and thus accounting for both the accumulation and distribution phases of retirement.

The major issue with these products has been portability—the ability for a participant to keep the benefit if they change jobs, or an even a more tangled web, if a plan sponsor changes platforms altogether, keeping the benefit with participants.

A solution may be near with this issue as whispers of an “exchange” for these types of products have quickly turned to open conversations. Look for something in the next six months or so to be announced in this regard.

Conclusion

The Department of Labor (DOL) issued “tips” on the evaluation and selection of target-date funds, which is usually a tip to get your act together as plan fiduciaries. It doesn’t matter so much what funds you have selected as your target dates of choice, it is how you’ve gone about selecting them. If you have not gone through a formal process to answer why you selected your funds when the DOL comes a knockin’, it may be time to update your fiduciary audit file.

Stephen Dopp CIMA, AIF, is a consultant and Senior Investment Analyst at Cafaro Greenleaf in Red Bank, New Jersey