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Solutions to the Target-Date Fund Dilemma
TDFs are not created equal. Too often, they are comprised of proprietary funds that restrict fiduciary oversight, and proposed DOL regulations will add transparency, but won’t affect a plan’s underlying strategy. Plan sponsors should review their investment options, analyze the "glide paths" of the funds and ensure that the strategy chosen best suits the needs and demographics of plan participants.
Bear markets make for greater scrutiny in the financial markets and, more specifically, financial products. However, just as many regulations seem to come after the damage is done (i.e., the legislation that followed the Enron crisis), the same fate may await target-date funds.
Since the early part of the decade, TDFs have seen their assets swell at parabolic rates. The competition has been fierce among mutual-fund companies to gather sticky assets in the lucrative 401(k) market. Unfortunately, in the face of stiff competition, many of those companies increased more risky asset classes in exchange for more attractive performance records during the bull markets of 2003 to 2007.
And many investors and plan sponsors evaluated these investments the way the fund companies anticipated they would -- based on performance.
Let’s face it, who in their right mind would buy a 2030 fund that was underperforming a competitor’s 2030 fund?
The problem is no two TDFs are created equal. For example, in a bull market, a "go-go" 2030 fund, comprised of 70 percent stock, should outperform its counterpart at another firm with a 50 percent stock exposure.
However, the converse will hold true in a market decline and will be more profound as the declines steepen.
The variations in returns illustrate the radical differences in allocations to stocks in the same target-date category with equity exposure ranging drastically from 65 percent to 25 percent. Take, for example, the market turmoil of 2008, when investment losses for funds with a target date of 2010 were as great as -41 percent and as small as -9 percent, with an average loss of -23 percent, according to Morningstar.
The Devil’s in the Details
The legislative guidance in the Pension Protection Act of 2006 made target-date funds a qualified default investment alternative (QDIA), providing safe-harbor protection for plan fiduciaries. They have quickly become staples in the retirement-plan marketplace.
However, just as in the case of plan sponsors and fiduciaries who monitor funds and, when necessary, remove certain funds from a plan’s investment options, similar oversight is required for target-date funds -- but it is often mismanaged.
According to industry leading ERISA attorney Fred Reish, with Reish & Reicher, his firm "finds general and vague language describing the selection and monitoring of target-date funds."
The majority of plan sponsors take great pride in the fund-review process as outlined in their investment policy statement, but they tend to fall short in this area when it comes to target-date funds. The reason is simple. Most target-date funds are comprised entirely of proprietary funds of the underlying fund family and/or its affiliates.
So, by design, the sponsors have limited oversight capabilities pertaining to the holdings -- at no fault of the plan sponsors.
However, according to Reish: "A plan sponsor must also be aware whether the management of the target-date fund is limited in its ability to select the underlying investments and/or has embedded conflicts of interest. (For example, is the manager of the target-date fund required, either as a practical matter or a written restriction, to select only the mutual funds of the affiliated manager?)"
It is unlikely for one investment-management company to have the best-in-class offering across the entire range of asset classes. Most would agree the premier retirement-plan investment menu is comprised of a multi-family, best-in-class investment lineup. The target-date strategy should not be any different.
Unfortunately, most plan sponsors include a single-family target-date line-up that invests completely in proprietary funds. For example, the three largest fund families invest completely in their own proprietary funds as underlying assets.
With estimates of 50 percent to 60 percent of asset flows going into target-date funds and plan sponsors lacking monitoring and removal capabilities of the underlying investments, it’s even more egregious for recommending proprietary target-date funds as the default investment.
Criteria and Standards
We reviewed 401(k) plan investments for a large institution with assets in excess of $330 million. It offered 16 investment choices including eight proprietary funds, of which seven are target-date funds. The proprietary TDFs attracted more than 40 percent of plan assets, or nearly $140 million.
The funds were then analyzed and scored using 10 criteria and standards from five different categories including fund characteristics (track record), performance, risk adjusted return, volatility and expenses. A fund is required to pass a minimum of seven of the 10 criteria to be considered passing.
A study of the underlying funds revealed all of the 20 underlying investments were, in fact, proprietary funds of the fund family. What’s worse is of those 20, eleven -- or 55 percent -- of the funds fail to meet fiduciary standards and are unsuitable investment options.
Unfortunately, none of this information was ever disclosed or reviewed by the plan-oversight committee -- until now. It’s a compromising situation that needs to be resolved.
I believe it is the duty and responsibility of fiduciaries to the plan participants to know this data and, more importantly, act on it. Anything less is, in my opinion, a breach of fiduciary obligation.
Just as deciding if your plan-investment philosophy is to have funds go down less in a down market (more conservative) or go up more in an up market (more aggressive), plan sponsors should first decide if they want their target-date funds to get their employees "to" or "through" retirement. The formula for this is the fund’s glide path.
The glide path is a predetermined allocation based on stocks, bonds and cash; the younger a participant, the more exposure to stock. As the participant nears retirement, the allocation automatically reduces the concentration in stock and shifts to more conservative bond and cash investments. In contrast to target-date mutual funds, these glide paths can be customized to meet the needs and the demographics of the plan participants.
This is a comparison of two sample glide paths ("to" and "through") illustrating the change in stock exposure over time.
The concept underlying the "through" approach is that investors will need to have their assets grow throughout retirement. Conversely, the "to" strategy provides less risk for retirement-aged investors who do not have the tolerance for riskier allocations to stock.
Neither is right nor wrong, but it is the duty of the plan committee and/or investment consultant to decide which strategy best suits the needs and demographics of plan participants. Not sure you are up for the task? Well, if you have a TDF in your investment line-up, you’ve already made the decision -- formally or by happenstance.
I am not sure how many of us can say we consciously decided on which style (to or though) was best for the plan when the TDF strategy was chosen, especially if they were chosen more than three years ago.
One reason is because there weren’t many tools available to do so -- until now.
I believe we should be judged on the decisions we make based on the prevailing circumstances at the time the decisions were made, so not having the tools available then makes the actions understandable.
However, as times have changed, so, too, have the circumstances. Plan sponsors can’t continue the old course of action as though they are still best practices today. With new procedures available, plan sponsors need to revisit the evaluation and choices of TDF strategies.
Quadrant and Glide-Path Analysis
Such prudent and documented selection processes should include:
1. Asset-allocation analysis;
2. Glide-path analysis;
3. Needs, ages and participants’ behaviors; and
4. Evaluation and monitoring of fees.
Each target date has a unique glide path and falls into one of four equity-exposure quadrants. It is incumbent upon plan sponsors and consultants to know and document the decisions they’ve made regarding both.
These tools and reports are designed to provide a framework for identifying and evaluating target-date funds that align more closely to a plan’s overall goals and its participants’ needs. The goal of the tools is to help plan sponsors assess their retirement plans’ desired level of equity exposure for participants at or near retirement and asset-class diversification -- two important characteristics of TDFs.
The framework also encourages plan sponsors to understand and consider the characteristics and behaviors of their workforce as part of the target-date-selection process -- factors the Department of Labor has also stated fiduciaries should take into account when designing the investment menu for a defined-contribution plan.
On Nov. 30, 2010, the DOL proposed new regulations requiring plan fiduciaries to provide enhanced disclosures about target-date funds to retirement-plan participants. The proposal would also amplify the investment information that must be disclosed about a plan’s qualified default investment alternative, even if it is not a target-date fund.
This transparency is intended to help participants make more informed decisions about their investments. However, the majority of participants investing in TDFs do so because they do not have the time, knowledge or inclination to analyze and manage their investment portfolio on a regular basis.
Only time will tell if providing participants with more information on a subject they rely on others to handle will create the results the DOL anticipated.
The proposed regulations do not encourage a revision of the target-date strategies, but do create additional transparency and oversight. In other words, plan participants will still be offered the same strategies creating the same investment outcome as before, but with government-mandated disclosures.
Rethinking TDF Strategy
The solution is to change the strategy and/or the process that produces it -- and not endorse the current product with greater government regulation.
In the multi-manager target-date-fund structure, the underlying mutual funds are chosen from a broad universe of investment managers. Taking it a step further, custom target-date models are used to create the target-date funds with investments that are already in the menu of options being monitored by the plan committee (and, if applicable, an independent investment consultant).
This gives greater fiduciary oversight and control to the plan sponsor, thus helping them fulfill their fiduciary obligations and making them better stewards for the participants.
Once the appropriate target-date glide-path philosophy has been established, the plan committee or investment consultant will, in a fiduciary capacity, create the target-date funds using the underlying plan-menu options.
The same monitoring standards given to the underlying funds will, by design, be given to the TDFs. If a fund is removed from the general fund line-up and replaced, it will automatically be removed and replaced within the target-date funds. This should be an automated process requiring no additional steps.
This transparency and uniformity provides an extra layer of fiduciary protection and overall prudence. Because investing in securities involves certain risks, projected guarantees cannot be made regarding the account values at the anticipated retirement age of the participant (the target date).
Moreover, many platforms allow for the inclusion of "satellite" strategies not typically offered in most retirement plans to build the custom target dates from areas such as commodities or emerging markets. They provide for an additional layer of diversification but are typically not recommended for a core investment menu.
When it comes to investment monitoring, fiduciary duties can be shared but cannot be transferred completely to another entity. So, the buck ultimately stops with the plan committee.
Since the committee approves the glide path and underlying investment options, custom TDFs give the plan sponsor greater control, customization and transparency. They also add an additional layer of fiduciary process and prudence.
However, creating the target date from a core line-up is not enough. The employer is still obligated to have a documented and prudent strategy for monitoring and replacing the underlying funds. If they don’t adhere to a structured process, then they will be following the same flawed target-date-fund strategy plaguing our industry.
Please note: Because investing in securities involves certain risks, no guarantees can be made regarding the account values at any time, including at or through retirement. The success or desired outcomes of target-date fund strategies cannot be guaranteed
Anthony Agbay is an independent retirement plan consultant specializing in fiduciary oversight strategies and retirement plan evaluation.
For related articles, please visit the Human Resources Executive Online website at http://www.hreonline.com/HRE/story.jsp?storyId=533327937
If you have comments, questions or would like a complimentary review of your Target-Date Funds, please contact Anthony below.