Scott Cameron, CFA
Target date funds are in the crosshairs of some members of Congress, as well as the Department of Labor (DOL) and the Securities and Exchange Commission (SEC). In fact, the DOL just announced proposed modifications to the qualified default investment alternative and participant disclosure regulations that would mandate increased disclosure for these products. Much of this focus stems from the increasing popularity of target date funds, as well as their perceived failure to protect investors during the most recent bear market.
Target date funds became hugely popular following the passage of the QDIA regulations because of the implicit government endorsement of these types of products and the relative ease of use and communication for most plan sponsors. It was very easy to tell participants to just select the option that is closest to when they will turn 65, or want to retire, and they would not need to worry about anything else. Unfortunately, in hindsight, the timing of the QDIA regulations and the adoption of these products was extremely poor in that most sponsors were adopting these funds at the heights of a bull market.
In the bear market of 2007-2009, target date funds behaved mostly as one would have expected given that they were invested in the stock and bond markets. These funds, to varying degrees and for a variety of reasons, experienced losses that caused concern among participants, plan sponsors, members of Congress, and regulators. Some of the criticisms that these funds received are well-founded, while others are derived from a lack of understanding of the nature of these products, how they work, and what composes their underlying investments. Never were these products designed to provide any guarantee of principal at the retirement date, nor any guarantee of retirement income for those invested in the funds. Instead, they were designed to invest in an underlying portfolio of stocks and bonds that the fund manager thought was appropriate for the average investor of that age. As the fund aged towards its target retirement date, the underlying portfolio would become more conservative automatically to account for investors’ shorter time horizon and the assumption of a more conservative risk tolerance.
The QDIA regulations created fiduciary protections for plan sponsors and enabled them to create better retirement solutions for their participants. Unfortunately, some plan sponsors thought it also relieved them of the responsibility for selecting and monitoring the QDIA product that they selected. The DOL has made clear that “The final regulation does not absolve fiduciaries of the duty to prudently select and monitor QDIAs.”1
In order for a plan sponsor to meet their fiduciary obligations to prudently select and monitor their target date QDIA funds a thorough analysis is necessary because of the underlying complexity of these products and their unique structure relative to the traditional “core” investment options that defined contribution plan sponsors are used to evaluating. At the most basic level plan sponsors need to evaluate the following characteristics of their target date fund series:
It is difficult to overstate the importance of the investment management firm in the analysis of a target date fund series. In addition to being responsible for the individual security selection within the component vehicles, the investment management firm is taking on additional responsibility with respect to the appropriate asset allocation for the participants invested in their funds, as well as the appropriate asset classes to include in a diversified portfolio for each participant. With this increase in responsibility comes the need for plan sponsors to better understand the capabilities of the firm they are selecting and the resources they have to develop and support their product. Plan sponsors should favor investment managers with experience in creating global asset allocation portfolios or investment managers that have outsourced the asset allocation decisions to a competent third party with experience in asset allocation.
Most traditional asset managers have historically focused on creating individual investment products that are targeted to single asset classes. Their unique skill is in identifying and selecting individual securities that will outperform their respective benchmarks. For firms with this background, the creation of a target date series requires additional skills in asset allocation that are not necessarily easy to develop.
Target date funds are designed to be a single investment option that is appropriate from the time an investor enters the workforce and starts saving for retirement all the way up to, and in some cases, through their retirement. Because of the expected longevity of these investment vehicles, and the expectation that plan sponsors do not want to shift target date fund series every few years to chase better products, it is important that the investment management firm be fully committed to their product. Commitment to the target date fund series shows up in the form of dedicated investment professionals focusing on managing the target date funds, fully developed research supporting their construction methodology, and a minimum level of asset scale within the products.
Resource commitment is also essential because of the dynamic nature of these products over their expected life. In the 7 or 8 years since these products started to become popular we have already seen changes in the equity glide paths of funds, as well as the asset classes that are included within the fund series. Contrary to how these products have been marketed, our expectation is that these funds will change over time to adjust to changing global capital markets and improved investment research. Understanding the need for these funds to change over time, it is important that the investment management firm have the ability to continue to improve their product with new research and best practices.
Ultimately, the evaluation of the investment management firm comes down to the people and processes. Experienced employees working in a stable work environment, with minimal turnover, should have the intellectual capital necessary to successfully manage these products over their lifetime. Supporting these individuals should be sound investment and operational processes that allow the investment professionals to meet the funds’ investment objectives while ensuring compliance with all applicable rules and regulations.
The first, and most important, decision an investment manager has to make in constructing a target date series is the selection of an equity glide path for their funds. Equity glide path is a term used to describe a fund’s changing allocation to stocks and bonds over its expected lifetime. All target date funds start their life with the majority of their assets allocated to equity investments, and as they get closer to the targeted retirement date they decrease the equity allocation and increase their exposure to fixed income investments.
Because of the difference in expected return and risk of stocks and bonds, differences in the equity glide path of competing funds will be one of the primary reasons target date funds have differing returns over time. At this point, and it seems unlikely to change in the future, the investment management industry has not settled on a single, appropriate glide path. Because of this, products that on the surface appear to be similar (two 2025 funds would generally be assumed to have the same investment objective), may in fact be markedly different in their composition, expected return, and volatility.
The DOL recognizes the importance of equity glide path in the overall construction of target date products. Their recently released proposed regulations would require greater disclosure for these products, focusing on providing more information, both written and graphical, regarding a fund’s equity glide path and how it changes over time.
While equity allocations differ among target date providers across all maturities, the largest differences appear as participants near the targeted retirement date. These differences are most
impactful to investors because it is at the stage where investors are nearing retirement that they generally have the largest account balance and therefore have the most at stake with regards to the performance of their investments. The differences in equity allocation as funds near retirement is a result of each investment manager defining their investment objectives differently, making different assumptions about the market, and weighting the individual risk factors (i.e. market risk, longevity risk, sequential risk, inflation risk, etc.) differently.
At the most basic level, differences in equity allocations near retirement are attributable to the “to versus through” retirement choice. Funds that are managed “to” retirement have a declining allocation to equities up until the target retirement date and settle into a static, conservative asset allocation after the target date. Funds managed “through” retirement have an equity allocation that continues to decline after the target retirement date and settles into a static asset allocation at some point beyond the retirement date.
The “to versus through” debate is somewhat of a flashpoint in the larger debate over the use and structure of target date funds within defined contribution plans. It serves as short-hand for a deeper, more nuanced analysis of the differences amongst the various products in the market. On the surface, the debate is about the appropriate structure of a fund’s glide path (the changing allocation to stocks and bonds over the fund’s expected lifetime). Digging a little deeper, this debate is a proxy for the larger one about the appropriate level of risk and equity exposure in these funds over their projected lifetimes.
Those in favor of a “to-retirement” glide path believe that the allocation should reach its most conservative point at the target date and stay static for all time periods after that date. Those in favor of a “through-retirement” glide path believe that the allocation should reach its most conservative point at some point (generally 10-20 years) after the target date and stay static for all time periods after that date. Because these funds have differing time horizons with respect their glide paths’ landing points, “to-retirement” series are generally more conservative in the years leading up to the retirement date.
In addition to the need to reach the landing point sooner, “to-retirement” managers generally define the investment problem differently than “through-retirement” managers. They focus more on short-term market risk, the protection of principal, and the desire to minimize the variability of outcomes among participants. “Through-retirement” managers generally focus more on maximizing retirement balances and managing to minimize inflation and longevity risk, even if it means somewhat higher exposure to short-term market risk.
While both sides argue their points passionately and persuasively, the market has shown this to be a very one-sided argument so far. According to a recent Morningstar research paper, the top 5 target date series of mutual funds account for over 85% of the assets invested in target date mutual funds. Of these 5 series, all are “through-retirement” funds2 Asset Class Selection . It is likely that this practice will continue given the investment firm’s interest in retaining assets “through-retirement.”
After the selection of the equity glide path, or as part of the equity glide path development, the investment manager needs to determine which asset classes are appropriate to include within the portfolios’ allocations. At the most basic level, each series generally includes allocations to cash investments, investment grade domestic bonds, domestic stocks, and international stocks.
The selection of appropriate asset classes should be dependent on a set of capital market assumptions developed by the investment manager that focuses on the risk, return, and correlation of each asset class. Based on the capital market assumptions the investment manager should select asset classes that when combined together provide the highest expected return for the lowest level of risk.
Asset class inclusion is one area that has seen the most change over the past few years. While most of these funds initially launched with allocations to the basic asset classes mentioned above, investment managers are becoming more sophisticated in the portfolio construction by adding new asset classes to their target date portfolios. The primary examples of this are managers including more inflation sensitive assets within their portfolios (TIPs, commodities, REITs, and in some cases direct real estate) as well as expanding the breadth of their international exposure (international fixed income, developed international small cap equities, and emerging market equities).
Once the glide path and asset allocation have been set, the investment management firm is responsible for selecting the individual investment managers to implement the funds’ design. Most target date funds are fund-of-funds with the target date fund allocating its money to individual funds investing in a single sub-asset class (i.e. U.S. large cap growth stocks). For target date fund managers, the choice for investment manager implementation differs along two dimensions: active/passive and proprietary/open-architecture.
Most investment managers are either active or passive in their investment style. Only a handful of the largest investment management firms (Vanguard, Fidelity, BlackRock) offer both actively managed and passively managed index-based funds. This bias at a firm level generally flows through to the target date fund series of the management firm. If they offer actively managed funds, their target date funds are actively managed, and vice versa.
Recently we have seen more investment managers adopting a hybrid approach to their target date fund series. In this hybrid approach, they are investing in a combination of active and passive mandates for the underlying funds. The hybrid approach is gaining traction because for even the best active managers, the ability to add value in each of the underlying asset classes included in a target date fund is difficult. These active managers are identifying which asset classes they have a unique ability to add value, actively managing those asset classes, and using passive mandates in the remaining asset classes. With this strategy underperformance in their non-core asset classes is minimized and does not dilute their “active” value added in their core asset classes. The hybrid approach also is being implemented because of its ability to drive down the total cost of the fund series.
Besides the active/passive dimension, target date fund series differ in whether they consist of only proprietary funds or if they are open-architecture investment options. The vast majority of target date funds use proprietary investment options from the target date funds’ investment manager. The concern with proprietary investment options is that the target date fund manager is limited in their selection of managers only to what they have available within their fund family. For smaller fund families, or fund families with a distinct investment style that is homogenous across all of their products, this can be a real limitation for the target date fund manager. For larger firms, this might be less of a problem, although any artificial limits on the universe of investment products available to the target date manager cannot be viewed as a positive item.
There are arguments for proprietary investment management within target date funds. It is generally safe to assume that proprietary fund options are better well-known to the target date investment manager, enabling them to better understand the strengths and weaknesses of each fund, its investment process, the people making the security selection decisions, and how their investment strategy might fit with the other strategies used by the target date fund. The use of proprietary funds also minimizes the number of parties involved in the funds, potentially reducing the total costs of the investment products.
While most target date options utilize proprietary funds within their target date series, there are multiple target date series that utilize an open-architecture approach to investment management. In these funds, the target date fund managers is responsible for the glide path, asset allocation, and selection of outside money managers, while the outside money managers invest in the individual securities per their mandate from the target date fund manager. Open-architecture products have the advantage of having access to a broader array of investment managers, the ability to identify “best-in-class” managers for each asset class, and the lack of appearance of a conflict that can exist for a proprietary fund solution. On the downside, open-architecture target date series are less common in mutual fund form (generally they are more readily available as collective investment trusts) and they include an additional layer of management that might make them more expensive than a proprietary solution. Finally, it is important to note that open-architecture by itself does not guarantee the funds will outperform proprietary solutions. The target date fund sponsor still needs to be successful in identifying managers that will outperform, not necessarily an easy feat for anyone.
Besides making the decisions regarding active/passive and proprietary/open-architecture, the implementation of investment managers is an area of broad discretion for the target date fund manager with both positive and negative results. Fund managers have the ability to seek out the best-in-class options within their fund family or they may veer towards investing in other funds within their investment lineup that have been overlooked by the market. As these products become more sophisticated, we are seeing target date fund managers move away from investing in a handful of retail fund options that the manager already sponsors, and creating more custom, institutionally focused investment options that are used by the target date funds.
The costs for managing these products create a headwind that can negatively affect investors’ ability to accumulate a sufficient retirement nest egg. Because of this, investment costs are important component of any target date fund analysis. For actively managed funds, plan sponsors should be evaluating the fund manager’s ability to add value in excess of the fees they charge for managing the portfolio. If it is unlikely that they cannot outperform on a net of fee basis, one should question whether it makes sense to use an actively managed product.
We continue to be strong proponents of target date funds within defined contribution plan investment lineups because of their ability to create diversified, balanced portfolios for those participants who are unwilling, or unable, to manage their retirement plan investments. While we believe in the virtue of these products, we are cognizant of their faults and weaknesses. In particular, there has been too much emphasis on proprietary solutions (both within the target date fund portfolio and with relationships between recordkeepers and asset managers), a lack of clarity with respect to glide path construction and the research supporting the chosen glide path, and a failure on the part of a large majority of the actively managed products to add any value net of their fees.
These products are still relatively young and it is our expectation that the industry will continue to evolve and improve these products over time. It starts with plan sponsors and participants demanding better solutions, and fund companies adjusting to learn from their mistakes and to provide better solutions for their clients. We are already seeing bundled recordkeeping providers opening up their platform to outside target date fund families (even for smaller plan sponsors) and more open-architecture and hybrid active/passive solutions coming to the market.
We do not believe that there is a single, optimal glide path for all plan sponsors, nor do we even believe that one side is right in the “to versus through” debate. Each plan sponsor needs to evaluate their specific needs to select a solution that best meets their investment objectives. Reasonable plan sponsors should begin by understanding themselves and their plan, its demographics, the income needs of their participants, the investment savvy of the participant population, and the objective for offering a target date fund series. Based on a thorough understanding of their own situation, they need to evaluate the alternative products available, the strengths and weaknesses of the investment managers, the stability of the investment management organization, the research and theory that went into the construction of the equity glide path and the asset allocation, which managers will be used to invest the portfolio, and the investment strategies that they will utilize to select the individual holdings.
The depth of analysis that is required can be daunting, but is necessary to ensure participants achieve the outcomes they expect and plan sponsors meet their obligations to the plan. This type of analysis does not lend itself well to the simple peer group comparisons and historical performance analysis that is commonly utilized to select other funds. Instead, it requires plan fiduciaries to dig deeper into their understanding of their investment objectives and the products that they utilize. If done successfully, plan fiduciaries can enable better outcomes for the participants that they serve; if done poorly, it can result in institutionalized performance-chasing that ensures perpetual under-performance.
† This white paper is not intended to be legal advice and should not be construed as such. Information relayed herein is representative of Multnomah Group’s experience and current understanding of the law. While Multnomah Group has made every reasonable effort to ensure that the information contained herein is factual, we do not warrant its accuracy. Additionally, this white paper does not embody a comprehensive legal study, but rather reflects the information most often sought by our clients. As the information contained herein is general in nature, you are urged to contact your legal adviser with specific questions related to your plan.
1 Employee Benefits Security Administration “Regulation Relating to Qualified Investment Alternatives in Participant-Directed Individual Account Plans”, April 2008.
2 Morningstar, “Target-Date Series Research Paper: 2010 Industry Survey”, 2010.