Monitoring and selection best practices. A White Paper Prepared by Transamerica Retirement Solutions

Transcription

1 Target Date Funds: Monitoring and selection best practices A White Paper Prepared by Transamerica Retirement Solutions

2 Contents Selecting and monitoring target date funds: a practical best practices approach 1 Electing a target date solution 1 Identifying best practices 2 How target date funds work 2 Developing your essential proposal 4 STEP ONE: Evaluate how the target date series works 4 STEP TWO: Evaluate the investment funds 8 STEP THREE: Evaluate the fund managers 10 Overall best practice: Put it all in writing in your Investment Policy Statement 13 Additional guidance may be on the way 13 Conclusion 13 For Plan Sponsor and Financial Professional Use Only

3 Selecting and monitoring target date funds: a practical best practices approach If your retirement plan currently includes or is considering the addition of target date funds, one thing is certain: These funds, once touted as a simple solution for retirement plan sponsors and their participants, are more complex than they originally seemed. Following the market s initial interest and adoption of target date fund solutions, retirement plan advisors and plan sponsors are now focused on the task of how to best select, evaluate, and monitor these solutions on an ongoing basis. For plan fiduciaries that have selected or are considering making a target date series part of their plan investment menu, there are numerous factors to consider. These include understanding and evaluating the target date fund series investment approach, its strategy for making asset allocation adjustments over time (the glide path ), and the underlying funds it is using. When target date fund series first appeared in the market, selection was a fairly straightforward process, primarily because there were only a handful of financial companies offering them. Nowadays, the universe is much larger partly in response to the Department of Labor s (DOL) approval of target date funds as a qualified default investment alternative (QDIA) as stipulated by the Pension Protection Act of At the same time, while funds have proliferated and usage has increased, performance has been in many cases lackluster over the past few years, especially among funds for those participants who are at or nearing retirement. This has led fiduciaries to realize that these investment options may warrant greater scrutiny than originally thought. Using an approved QDIA investment does not relieve fiduciaries of their responsibility to evaluate and monitor the specific series they have chosen with the same prudent process and due diligence they would use with other investment options. Since all target date fund series are not alike, making effective comparisons is not always straightforward. In fact, when it comes to target date fund series, the QDIA safe harbor may have left fiduciaries vulnerable, since there are no hard and fast rules as to how to compare one series to another. Different target date fund series will have different approaches to asset allocation, long-term investment strategies, and assumptions about what level of income investors will need in retirement. As the fiduciary, you ll have to understand how these differences may impact your plan participants retirement accounts. If you re not fully informed when evaluating and selecting a target date fund series, you may be exposed to significant risk and not afforded, under the Pension Protection Act, the relief you would expect to have especially if you do not have sufficient evidence of prudent selection and monitoring of your plan s QDIA funds. Electing a target date solution As with any investment option you consider, your selection of a target date fund solution may be influenced in part by philosophy what you believe to be your responsibility toward your participants and what you consider to be in their best interests. However, other aspects of the decision-making process are more objective, and may be influenced by the characteristics of your employee population, such as their average age, level of financial sophistication, investment preferences, and tolerance for risk. If an analysis of your plan indicates participants may not be adequately diversified in their portfolios, or that they would welcome a prepackaged investment solution, offering a target date fund series as an option may make great sense. But those indicators alone won t absolve you of your fiduciary responsibility to ensure you ve made a careful and prudent selection. 1

4 Identifying best practices As a plan fiduciary, you are expected to: Perform an independent investigation of the merits of particular funds. Understand underlying investment philosophy, objectives, risks, and investment management of the funds. Examine the fund providers and the reasonableness of the fees being charged for the services to be performed. Have an approach in place for monitoring the activities and reviewing the performance of the providers. Thoroughly document the prudent process you ve followed to perform these steps. So how can you most effectively evaluate, select, and monitor target date fund series which theoretically have a common purpose, yet can have very different approaches to achieving that common purpose? First, it might help to consider the selection of a target date fund series exactly the same way you might consider the selection of any other vendor or provider for your plan and create a formal Request for Proposal (RFP). This RFP, which can be provided to potential target date fund providers, should ask key questions that will shed the most light on the differences among various target date solutions so you can make informed decisions. This paper outlines these critical questions as well as how to evaluate the answers. How target date funds work The decision of whether to use a target date fund series must begin with a clear understanding of how these investment solutions are designed to work. At the most basic level, all target date fund series have a similar approach: Each offers a series of funds with its own target date a year closest to when the participant expects to retire. The funds will automatically readjust and rebalance their initial asset allocation mix over the years, generally moving from a more aggressive to a more conservative asset mix through what is commonly referred to as the fund s glide path. Target date fund series are typically constructed as a fund of funds, offering exposure to a variety of asset classes through the underlying mutual funds, or other pooled investments, such as collective investment trusts. When target date fund series first came to market, their portfolios consisted primarily of some mixture of stocks, bonds, and cash. Today those providers that offer target date fund series have begun to revisit their overall approach and strategy by using a broader array of investment vehicles, such as real estate and commodities, to boost returns and create more efficient portfolios utilizing the benefits of diversification. The trend toward using more alternative or active investments within a target date fund series can also make this once rather low-cost option more expensive than it was before. It is likely that the marketplace will continue to see more innovations in target date fund series design, which may further complicate your decision-making process. 2

5 A bit of background: How target date funds evolved Target date funds gained traction in the mainstream more than a decade ago. They were developed in response to a need for a simpler solution for retirement plan participants who required more guidance in making investment selections. Too many participants were taking either too much risk or not enough, and many of them were not diversifying their portfolios or adjusting their account balances over time. Both plan sponsors and participants were poised to embrace any solution that might make the investment decision-making process easier and more effective. When target date funds were introduced, they caught on quickly perhaps before they were even fully understood by plan sponsors and their employees. Essentially, target date fund series were based on the premise that investors with a common goal (retirement) and a common investment time frame (years to retirement) might all benefit from sharing an asset allocation strategy that was already and designed to carry them through until their anticipated retirement date. The phrase set it and forget it was soon linked to target date funds. This positioning of the option clearly resonated with plan sponsors who wanted to accomplish two goals: provide their participants with a professionally managed retirement investment solution, and increase participation among those employees who were reluctant to make or incapable of making ongoing investment decisions. An unintended result of the goal to provide a solution for participants who are unwilling to make or incapable of making investment decisions has been to reinforce non-attentive participant behaviors those participants who choose to be disengaged from the retirement planning process. This often leaves those plan participants unaware of what they are invested in, how their investment needs may change over time as their general financial needs change, and with the impression that they can retire when they expect to. Target date fund series are not intended to adequately address these issues; however, they often unintentionally reinforce behaviors that can have dire consequences for individual participants. 3

6 Developing your essential proposal Despite the variations you ll encounter when comparing target date fund series, it is possible to gain significant insights by focusing on several common key attributes: Basic objectives of the investment strategy, such as whether the series seeks to maximize consumption, provide a reasonable range of outcomes, or provide a floor of retirement income. Whether the series follows a to or through retirement approach and the overall trajectory of the glide path (e.g., how frequently the allocations become more conservative over time). Whether the target date fund series uses an allocation methodology that has an aggressive or conservative emphasis versus other series with a similar objective, and whether the management of the asset allocation of the series is primarily strategic or tactical. Indexing versus active management of underlying funds. Asset classes, number of underlying funds, degree of diversification, and range of end-dates. Asset managers, and whether underlying funds are purely proprietary or include nonproprietary funds. Assumptions made by the series as to the average investor s characteristics. Strength of education curriculum and the ability of the provider to assist with the introduction of the target date fund series to the plan s participant base. Overall expenses examining either institutional or retail funds being used. Before you get started taking a more detailed look at target date solutions, consider your answer to this question: Why do you want your plan to use target date funds in the first place? That single question (and your answer) can lead to a host of other considerations. For example, how will plan participants benefit from having this type of prepackaged single-choice option? Does your plan offer participants other ways to achieve a diversified portfolio for example, through a guidance or advice program, or managed accounts? Does your plan currently use a default option, and if so, have employees typically remained invested in that option? Do you envision using the target date fund series as a default option? If you believe that a target date solution is in the best interests of plan participants, you ll still need to know more, but at least you can be confident you aren t making a decision to add the solution simply because it has become a trend for employers to do so. In addition, taking the time to understand how to compare the funds within the target date series will enable you to gain more perspective on how you might monitor target date solutions you may already have introduced into your plan, and whether you should consider keeping or replacing them. Now let s look at the common questions plan fiduciaries should be asking in order to make some valid comparisons among target date funds, as well as how to make sense of the answers so you can determine the best solutions for your plan and your participants. STEP ONE: Evaluate how the target date series works Your plan s Investment Policy Statement (IPS) should serve as your definitive guide for evaluating whether a target date fund series essential philosophy is a good fit for your plan. Be sure to ask the following types of questions in order to fully understand how the specific target date funds have been designed. 1 What is the primary objective of the provider s target date fund series? How does that objective impact the relative aggressive or conservative nature of the investment approach? All target date fund series have the same basic premise retirement savings but understanding the investment objective is a critical first step in evaluating a target date fund series for your retirement plan. Within the same objective, there can be a variety of design decisions that need to be explored as well. Your decisions should be based on a combination of your core philosophy about investing and practical considerations. In general, you should be aware of the three main types of target date solutions. Each strategy can be indicative of how well the solution s objectives correspond with those of your plan, and how aggressively or conservatively the solution might invest and manage assets. 4

7 Objective A: When maximum return on investment is sought a more aggressive approach is required, resulting in greater exposure to investment risk. Target date fund series focused on this goal are mostly seeking to provide a higher level of long-term income replacement at retirement, assuming all investors will need a certain level of their pre-retirement income generally at least 70% in total, part of which will come from Social Security benefits. The goal of maximum returns is meant to be achieved by building a larger accumulation at the target date fund s end-date, which will allow participants to withdraw greater amounts in retirement. Since the main focus is asset growth, these target date funds typically have a higher equity allocation throughout the glide path in order to offer more growth potential, which could potentially lead to a higher level of volatility within a portfolio at various times. Naturally, a more aggressive strategy carries more risk, and this can have significant implications for plan participants, especially if there are sharp market declines just prior to the retirement target date. Objective B: When consistency in investment returns is desired a more conservative approach is generally used, requiring a more diverse set of investment choices. By emphasizing stability of returns as a primary objective, the fund s asset manager is trying to ensure investors can regularly draw down a reliable amount of income during their retirement years. These target date funds will typically have a lower allocation to equities throughout the glide path to avoid dramatic declines in portfolio value. Rather than focusing on growth in asset values, the idea is to seek consistency and predictability of risk and return over the life of the fund. This objective does not assume the need to meet a generalized income replacement target, but rather uses broader assumptions about the investor population, such as life expectancy, to determine what an adequate ending accumulation might be. Objective C: When lifetime income is the desired outcome minimum guarantees on accumulated assets are utilized. Target date funds with this objective are generally retirement income funds, designed for investors to use once they retire. Though not a target date fund per se, retirement income funds may be useful for plan participants once they reach their targeted end-date or for those who are so close to retirement age that a longer-term target date fund is not appropriate. The underlying objective is to provide lifetime income at the point of and throughout retirement, utilizing a custom deferred fixed annuity or guaranteed minimum withdrawal benefit feature within an annuity. As the fiduciary, you ll need to decide whether you want plan participants to have this type of retirement option in addition to accumulation funds. Best practice: You should begin your evaluation and selection process by seeking out target date fund series with objectives most consistent with your plan s stated investment philosophy. These issues should be outlined within your plan s Investment Policy Statement (IPS). Be sure to identify the objectives most consistent with your plan s mission. What other types of investments are being offered within the plan menu, and how do these options complement the addition of a target date fund series? Remember, target date funds are designed for participants who are reluctant to rely on their own ability to build a diversified portfolio. Your plan menu should provide a broad array of investment choices, ranging from conservative to aggressive, so you ll need to determine where a target date fund series might fit into this risk/reward spectrum. 5

8 2 Are the target date funds intended to be to retirement or through retirement investments? What increments do the funds come in for example, 5 or 10 years? Another primary indicator of the underlying strategy of a target date fund is represented by whether its objective is considered accomplished once the fund reaches the retirement year (the to retirement approach), or the fund provider expects investors would remain in the fund throughout their retirement (the through retirement approach). Since to funds assume participants will withdraw assets at retirement, they generally will have a lower equity allocation at the end-date. This strategy focuses more on preserving principal. Through funds assume participants will remain invested throughout retirement, so typically they will have greater exposure to equities at the end-date. This strategy emphasizes the continuing need for underlying assets to grow even while participants are making withdrawals. The main decision you ll make here depends largely on the expected needs and behavior of the majority of your plan participants, and this might be assessed by reviewing past behavior. Once participants leave employment, do they typically keep their retirement assets invested with their employer, or do they roll them over to a new employer or to an IRA? If you believe participants would benefit from continuing portfolio management that will serve them during their retirement years, the through methodology might be a better option. On the other hand, if there is considerable turnover in the employee base, with many participants moving their account balances out of the plan at termination, a to strategy might be more appropriate, as it attempts to maintain more stability of the portfolios over time. Both decisions to versus through and maximizing consumption versus aiming for relatively stable returns impact the underlying trajectory of a fund s glide path. Generally, funds will depict their glide paths visually with representative pie charts illustrating the way portfolio composition will change over the years. You may see a more gradual adjustment from equities to fixed income or a more dramatic shift in the later years of the fund s time horizon. Neither approach is necessarily better but the level of risk assumed should be compatible with your retirement plan s overall investment philosophy and the participants needs. In addition, you should take into consideration the demographics of your participant base when identifying the appropriate end-dates for the target date funds. Originally, most target date funds were designed to capture 10-year increments for the end-dates, which often meant that investors at very different stages in their careers would all be assigned a common investment strategy. Nowadays, funds are using shorter intervals for end-dates, such as five years, so that there is a greater ability for investors to select a target date fund that more closely matches their expected retirement year. Best practice: Evaluate what makes the most sense for your employees in general, and understand that whichever approach you prefer, this will need to be communicated to plan participants to consider as part of their decision-making process. Employees who choose to invest in a target date fund series should understand the purpose and long-term nature of these investment vehicles, and be prepared to consider what options they may choose to exercise once they leave employment. Whether you select to or through funds will impact the level of risk plan participants may be assuming, as well as their future distribution opportunities. Employees who are many years away from retirement may not know at the outset whether they will remain invested in a target date fund for the life of the fund, while those closer to retirement may appreciate knowing that this decision can be maintained once they do retire. These diverse needs must be weighed against each other in order to determine which option makes the most sense for the majority of plan participants. An overarching objective when selecting any target date fund series should be to meet the needs of the majority of your plan participants. Each age group should have a truly appropriate target date option; in general, the more specificity you can provide in terms of these end-dates, the better, so it s probably wiser to look for series that offer five-year rather than 10-year increments to ensure the underlying investment strategy can truly be as targeted as possible. 6

9 3 Do the target date funds use a strategic or tactical approach to the glide path? How often and under what circumstances do fund managers revisit their initial strategy? Under what circumstances, if any, does the manager of the target date fund have discretion to vary from the stated asset classes, asset allocations, and glide path originally provided? Target date funds have a series of asset allocation targets over the life of the fund this constitutes their glide path. Another critical aspect of the investment philosophy and approach of target date fund series providers is their use of a strategic versus tactical glide path model. As the fiduciary, you need to understand how participants will be impacted by either glide path model under various market conditions. A strategic approach is based on long-term forecasts of asset class risks and returns as well as assumptions about how these asset classes may behave in the future. The asset allocation reflects these long-term projections. It is generally designed to remain fairly static, although asset managers usually reserve the right to make changes if necessary. The forecasts may be updated on a regular basis and the glide path adjusted accordingly, but the focus remains on long-term forecasts rather than shorter-term market conditions. Using this approach probably means a smaller degree of turnover within the portfolios. If a fund favors a strategic approach, you ll need to find out the circumstances under which its manager might make significant adjustments, especially if there are dramatic changes in the markets. A tactical approach begins with the forecasting of asset class risks and returns, but allows more latitude than a strategic approach when responding to short-term market opportunities. An asset manager using a tactical approach could produce greater volatility within the funds by adjusting portfolio composition and the glide path itself in order to react to shorter-term changes in the marketplace. If a fund uses this approach, you ll need to look closely at when and how often the asset manager can make portfolio changes, whether this adds to the cost of the funds, and the kind of notification provided with respect to these changes. There may be more emphasis on security selection, which could mean underlying funds are replaced more frequently. Best practice: Both strategic and tactical asset allocation methodologies will require fiduciaries to monitor performance closely everything depends on how well the fund s asset managers are able to deliver and whether you re satisfied your plan participants are benefitting from the approach. A strategic glide path can often be more cost-efficient than a tactical one and may provide a less volatile risk/reward experience. On the other hand, a successful tactical glide path approach has the potential to capture additional returns, although it could also incur more losses. Find out about the scope of the asset manager s discretionary control over the underlying assets. Make sure the fund provider can assure you that it will send comprehensive disclosure to you and plan participants when changes or variations occur. Again, your participants general risk tolerance is critical, as is your confidence in the asset managers, their track record with target date and other types of funds, and the performance of their funds. Your plan advisor can help you evaluate how well asset managers have been able to deliver on their stated objectives. All of this leads to a final question about investment strategy. 7

10 4 Do the funds favor active or passive management, or a combination of both? There are two ways a fund can try to generate returns; both require the oversight of a fund s asset manager, but one approach is a bit less dependent on that manager s investment expertise than the other. Choosing between these methods may be based purely on preferred philosophy, but the decision can also affect your plan s costs. A passive, or indexing, strategy means the fund simply seeks to mirror the investment holdings in a representative benchmark. Since there s less for the asset manager to do when selecting investments, costs for indexed funds are lower than those of active funds. Success or failure of this approach is measured by how closely the strategy tracks the benchmark s performance. An active strategy also utilizes a benchmark, but tries to add value above and beyond the returns that might be expected from that benchmark. The asset manager makes choices about how heavily to weight various holdings (differently from the benchmark) or which additional securities to include. Success or failure of this approach is measured by the manager s ability to outperform the benchmark (net of fees) in order to enhance returns. In evaluating whether actively managed target date funds make sense for your plan, you ll need to know more about the track record of the fund s asset managers and look closely at the historical performance of their funds. If you prefer actively managed strategies, you should especially look closely at the management of each of the series funds. Best practice: Carefully assess the costs of using actively managed funds, and work with your plan s advisor to explore the track records of the asset managers. The level of financial sophistication of your employees and the other types of investment options included in your plan are also issues to take under consideration. You should examine the fund lineup of your plan as a whole to identify the current balance of active versus passive investment options available to your employees. It s likely your plan already provides some mixture of active and passive funds. Do employees currently show any preference for one or the other of these strategies? Do the cost savings that might be realized by using indexed funds outweigh the opportunity to offer the potential for greater returns? STEP TWO: Evaluate the investment funds Target date fund series are typically designed as fund of funds so the underlying investments used within the asset allocation mix should be scrutinized on their own merits. Several factors will distinguish one fund from another, including the impact on costs. The following types of questions will help you better assess the underlying structure of the funds. 1 What asset classes do the target date funds include? How many underlying funds are used, and how are these funds selected? Are these primarily proprietary funds or are there multiple fund families and fund managers? Virtually all target date fund series will use traditional asset classes, such as equities, fixed income, and money market. Within the equities category, large-, mid-, and small-capitalization stocks may be included, as well as international exposure. There are many different types of fixed-income funds, so it is extremely important to be aware of the quality of the bonds that might be included within an underlying fund. Less than highly rated bonds often offer greater return potential because the bondholder is taking greater risk. However, fiduciaries must decide whether these types of risks are appropriate, and ensure, as fiduciaries, they clearly understand what it means to undertake these risks on behalf of the plan. Recently, many target date fund series have started including nontraditional alternative asset classes, such as Real Estate Investment Trusts (REITs), emerging markets, commodities, and currency, as well as more exotic hedge fund-like strategies. These types of investments generally have a lower correlation with traditional asset classes, so diversification can be enhanced, and there is the potential for higher expected returns. 8

11 Some target date fund series use only a handful of underlying funds, while others may use dozens. Both approaches can be well diversified, although using a larger number of funds may offer two advantages: greater specificity of fulfilling the desired asset classes and greater flexibility to remove and replace certain underlying funds. The flip side of using multiple funds is the potential additional cost, monitoring requirements, and the possibility of redundancy in holdings. It s important to note that if you favor a passive strategy for target date funds, an indexed fund that is successfully tracking its benchmark is less likely to rely on investment selection. Instead, its returns are driven more by the asset allocation and glide path decisions. An actively managed fund is influenced by these decisions too, but successful security selection will have the greatest impact when it comes to outperforming the benchmark. Another essential area of comparison among target date fund series is whether the asset managers use their own firms proprietary funds exclusively or the underlying funds represent multiple companies and managers. The use of proprietary funds within a target date fund series may also limit the flexibility of the managers to use certain asset classes if they don t have funds with that objective. In addition, from a fiduciary perspective, there is generally no control over what securities are used by the provider of the target date fund series. The only method of change is to replace the entire series with that of a different provider. This highlights the need for attentive due diligence at the onset of selecting a target date fund series, since the method of change is so disruptive. You ll want to ask how long the fund s asset managers have been involved in making investment decisions about target date funds, and how successful they have been in meeting or exceeding their funds benchmarks. Best practice: In general, when selecting a target date fund, it s probably wiser to focus on those emphasizing broad diversification among many different underlying funds, rather than those that rely on a limited number of funds. Although using fewer funds may help to minimize operating costs of the fund, there is also a greater reliance on how well a smaller universe of funds will perform. The greater the diversification of the target date fund, the greater the potential for balancing risk and reward minimizing dramatic volatility. An asset manager who uses only proprietary funds should have a strong historic track record, and the limitations imposed by this structure should be well understood. A possible advantage of using a proprietary target fund option is that providers may be more willing to negotiate fees and services if you decide to use their target date funds exclusively. If a fund provider uses multiple managers from various companies, take a close look at those underlying funds, their holdings, and the track record of the asset managers. You may have a preference for certain providers, especially if you have already performed due diligence on their other funds and some of these are included in your plan s investment menu. Your plan advisor can help you determine which asset managers have demonstrated strong abilities when it comes to delivering consistent returns. 2 What benchmarks are effective when evaluating fund performance of a specific target date fund series? How do you compare different target date fund series? First off, it s important to recognize the challenge of effectively benchmarking a target date fund series performance, as there is no standard benchmark that every fiduciary can rely upon. When selecting a target date fund series you should ask the series provider to refer you to a representative benchmark considered applicable, and you can also review the historical performance of the underlying funds within the target date fund series. Benchmarking a fund within the series can be accomplished by comparing its performance to other target date funds within other target date fund series that have the same end-dates (e.g., 5, 10, 15, 20 years). Another benchmark to consider is comparing the fund to a blend of indices for the different asset classes held. These industry target date fund indices as well as peer groups help you make comparisons, and you can use them to evaluate relative performance and explore what factors may be driving returns and risk. 9

12 Best practice: Don t assume you can sit back and not carefully evaluate the underlying strategies that affect performance of target date funds. As a fiduciary, you are charged with educating yourself, and are expected to seek out guidance from those who are more knowledgeable about these investment options to help improve your understanding of target date fund series. Work with your advisor to establish a method to evaluate and compare one target date fund series by itself and to other series. Making an authentic comparison generally involves applying investment theory, so you are able to genuinely look under the hood to analyze the fund s approach and assumptions. Identify those funds that have, at the very least, a three-year performance track record, and see if you might be able to utilize some of the industry s newer benchmarking solutions, such as those available from Morningstar and Dow Jones. To the extent possible, seek out tools that can help you and your plan advisor evaluate performance in comparison to other target date funds in the industry, so you can both determine whether the way you are analyzing these funds is reasonable and appropriate. 3 What are the fees for the target date funds? Do the funds use retail or institutional share classes of underlying funds? Of course, for a plan fiduciary, it s always essential to consider plan costs. You are responsible for determining whether costs are reasonable and justified based on the services being rendered. With target date funds, the challenge of fee transparency can be more acute, as the funds may have an overall management fee as well as operating expenses for the underlying funds. Emphasizing indexed rather than active funds is often one way to provide plan participants with a lower-cost option. On the other hand, retirement investing is a long-term proposition, and participants may well benefit from the opportunity to invest in funds that can outperform an index and deliver potentially greater returns. You may be able to realize another potential cost-saving opportunity by focusing on the share classes of the mutual funds used within the target date fund. Institutional share class funds are priced lower than retail funds, which may be an extremely important advantage. Employers with a large participant base should be able to command the use of institutional share class funds. If a target date fund does not offer a lower share class for its underlying funds, you should inquire whether this is a possibility. Best practice: Fees are an important area of potential negotiation with a fund provider. Be sure to initiate a conversation with the provider about fee structure and methods for reducing plan expenses. STEP THREE: Evaluate the fund managers Although identifying the right target date fund is essential, the decision may go beyond evaluation of the investments themselves. Certain fund providers may be able to offer your plan additional advantages that can be important to enhancing the retirement program as a whole. The following types of questions will help you distinguish any added value that might be represented by a fund provider. 1 How much experience has the provider had with defined contribution plans and plan design? The defined contribution marketplace continues to be a dynamic one, and effective plan design is a critical component for your plan s success. Providers with experience in plan design, including features such as automatic enrollment and contribution escalation, and the rules surrounding qualified default investment alternatives (QDIAs) will be your best possible partners when it comes to helping you to act in your participants best interests. Make sure you ask fund providers for details regarding their experience in plan design and implementation, including their ability to help you facilitate any plan changes that may be necessary. Best practice: Look for a provider that has an established track record in the defined contribution marketplace. Ask providers for client references from companies that might have similar needs to your own, and be sure to contact those references. In addition, if you are intending to use target date funds as a QDIA, your choice must comply with the criteria set forth in the Department of Labor s regulations for QDIAs. 10

13 Does your plan need a customized solution? One significant trend in the target date fund industry is the emergence of the customized target date approach. Rather than selecting a prepackaged series of funds, plan sponsors can work with a provider to develop an asset allocation, fund mix, and glide path designed to reflect a plan s specific criteria and needs. This approach is not an easy undertaking, and it can put a greater burden on the plan sponsor to select and monitor the underlying funds. However, it may warrant consideration if you believe it might be an effective solution for your plan and its participants. Advantages of prepackaged funds These funds can be more cost-efficient since they have been designed to provide some economies of scale. They can also make it easier for participants to move their target date investment from one employer to another, or to transfer the fund balance to an IRA. Advantages of a customized solution Prepackaged funds do rely on the one size fits all approach despite the fact that not everyone with the same target retirement date may share the same goals and tolerance for risk. However, with customization, plan sponsors can tailor the target date solution to reflect the needs of their employee base. Glide paths can also be tailored for risk tolerance. By customizing your plan s target date series, you may be able to exercise greater control and flexibility in matching the investment philosophy, objectives, and investment strategy of the target date solution to the mission of your plan. In addition, it may be easier to quickly respond to disappointing performance by replacing an underlying fund from within a broader universe, rather than waiting for the fund provider to do so. This is more difficult to do with a prepackaged target date fund in which replacement of underlying funds is the responsibility of the asset manager. What customization involves Being involved in making structural design decisions for a target date solution requires you to have an in-depth knowledge of your participant base, which will help drive those decisions. The trade-off for this flexibility can be additional management fees and administrative costs, as well as operational complexities, when using funds from different firms in combination with one another. Weighing your options If you ve reviewed the field of current off-the-shelf target date funds and believe they do not really meet your needs, ask yourself why this is the case. Do your plan participants require different types of glide paths and investments? Are there certain fund companies within your plan s investment lineup you believe already offer the best-of-breed investment opportunities? Do you believe a target date solution is what most employees are looking for, and that this option will be utilized by many of them as a long-term investment strategy? Other solutions might involve creating a risk overlay that distinguishes among the funds in the series, allowing plan participants to select a fund based not just on years to retirement, but alternatively on tolerance for risk. Before embarking on a customization solution, you should be aware that it can be a very detailed and timeintensive process. As the fiduciary, you along with your plan advisor will have to be more hands-on than ever in making investment selections and in monitoring those selections. Participants may be able to address their individual investment needs another way, for example, through access to an advice or managed account program. However, if the target date solution is of primary value to your plan participants, taking the time and effort to enhance that offering may be worthwhile and the best way to fulfill your fiduciary responsibility. 11

14 Your fund provider should be able to assist with this compliance effort. As your plan evolves, a provider s flexibility and overall expertise with defined contribution plan design will help ensure your participants needs can continue to be met. 2 How much experience has the fund s asset manager had with target date funds? What is the firm s commitment to research and innovation with respect to its investment strategies? Target date funds have proliferated over the past few years, so you are likely to discover that many providers have limited track records with them. However, you can and should evaluate the strengths of the fund s asset managers in general their backgrounds, years of experience, and ability to navigate various market cycles successfully. Best practice: Include in your analysis the target date funds that have been in existence for the longest period of time. Even if you do not select these funds, they should provide a reasonable barometer of how these types of funds have weathered the markets and what strategies were employed to enhance investment performance. You should work with your plan s advisor to identify critical attributes that might reflect proven asset managers and to organize data to make comparisons. Areas that may be significant include a company s ability to offer a dedicated research team, state-ofthe-art technology, and demonstrated thought leadership within the industry. Find out what resources the company has committed to research and scenario analysis, and ask it to provide specific examples of technologies it utilizes and innovations and enhancements it s introduced to its funds over time, if any. 3 How much flexibility can the provider offer in terms of tailoring solutions and negotiating an attractive fee structure? You may decide to use a prepackaged target date solution, or explore whether you want to implement a customized solution. Customization may be time-consuming, and is not always necessary or appropriate. However, a provider that can work with you to efficiently tailor a target date solution inclusive of design and investment options may be a better candidate than one that cannot. In addition, you have a responsibility as the fiduciary to ensure your participants best interests are being met under the fee structure associated with the target date fund series. You should also determine whether fees are charged to the plan sponsor or its participants, and whether there are any ways to offset expenses through revenue sharing arrangements. The fund provider should be prepared to discuss its fees in detail and willing to explore alternatives that may help reduce expenses. 12

15 Objective D: What level of support for employee education and communications does the provider offer? As already stated, target date funds are not as simple as they may appear, and it s crucial for plan participants to understand how they work and how to use them effectively in order to make a wellinformed decision. Numerous recent studies indicate that many plan participants have serious misconceptions about the fundamental features of target date funds and the associated risks of investing in these options. Make sure any provider you select has the ability to assist you in developing a strong communications program for employees that clearly describes the new target date funds. You should be able to examine materials the provider has provided to other clients. These are the materials your employees will be relying upon to understand the funds, and they should be straightforward in describing the investment approach and features. You may also want to know how much on-site and educational support the provider can offer, and whether there is an additional cost for any of these services. Best practice: Review communication materials from each provider, and ask whether they have any research documenting the success of these communications as part of an overall education program. Be sure the provider is prepared to help you customize your own communications to the extent necessary, and has a team in place to work with you in educating employees. Also ask the provider how it responds to and communicates regulatory requirements on fees and investmentrelated disclosures. Overall best practice: Put it all in writing in your Investment Policy Statement The Employee Retirement Income Security Act of 1974 (ERISA) requires that fiduciaries employ a prudent process in their decision making. So it is important for you to document in your IPS the steps you take to evaluate and select investment options, as well as the strategies in place to remove funds and replace them if they are underperforming or no longer meet the criteria of your IPS. With target date funds, you cannot simply set and forget but must remain vigilant in assessing whether the funds are providing the benefits promised as part of the selection process. You must be prepared to respond appropriately when issues arise with any investment option. So work with your plan advisor to ensure your IPS is up to date and outlines the prudent process you will follow. Additional guidance may be on the way Your role as a fiduciary when trying to evaluate, select, and monitor target date funds may soon be clarified. The DOL and Securities and Exchange Commission (SEC) are now developing rules for employers and fund providers to follow when offering target date funds as investment choices in retirement plans. The first piece of guidance has been released by the DOL and the SEC an investor bulletin focusing on how target date funds operate and the risks associated with target date investments. The DOL and the SEC have also proposed disclosure regulations requiring that plan participants who invest, or are eligible to invest, in target date funds receive certain detailed information. Conclusion Evaluating, selecting, and monitoring target date series may pose special challenges, but once you re aware of the key characteristics that distinguish one fund from another, and how to interpret them, making improvements to your prudent process is that much easier. By understanding the needs of your plan participants and making a concerted effort to match those needs to funds with suitable investment objectives, style, and methodology, you can better ensure your participants will benefit from what these funds have to offer. 13

16 About Transamerica Retirement Solutions Transamerica Retirement Solutions (Transamerica) is a leading provider of customized retirement plan solutions for organizations of every size. Transamerica partners with financial advisors, third party administrators, and consultants to cover the entire spectrum of defined benefit and defined contribution plans, including: 401(k) and 403(b) (Traditional and Roth); 457; profit sharing; money purchase; cash balance; Taft-Hartley; multiple employer plans; nonqualified deferred compensation; and rollover and Roth IRA. Transamerica helps more than three million retirement plan participants save and invest wisely to secure their retirement dreams. For more information about Transamerica Retirement Solutions Corporation, please visit Nothing presented herein is intended to constitute legal or investment advice, and no investment or plan design decision should be made solely based on any information provided herein. Nothing presented herein should be construed as a recommendation to purchase or sell a particular investment or follow any investment technique or strategy. Any forward-looking statements are based on assumptions and actual results are expected to vary from any such statements. While Transamerica has used reasonable efforts to obtain information from reliable sources, we make no representation or warranties as to the accuracy, reliability, or completeness of third-party information presented herein. Past performance is no guarantee of future results. There can be no assurance that any particular asset class will outperform another asset class. There is a risk of loss from an investment in securities. This paper is general in nature and not intended as tax or legal advice. Because each employer is unique, an employer should consider its individual circumstances when evaluating a defined benefit plan administrative solution and should consult their retirement plan and/or legal advisor. 440 Mamaroneck Avenue, Harrison, NY TRSC Transamerica Retirement Solutions Corporation