The Newport Group s Investment and Fiduciary Consulting practice has

Transcription

1 A Prudent Approach to Evaluating Target Date Funds Julie Leinenbach, CFA, FSA Director of Asset Allocation The Newport Group November 2015 The Newport Group s Investment and Fiduciary Consulting practice has developed a robust methodology for evaluating and monitoring targetdate funds. It is designed to be a prudent process that lives up to the rigorous demands of ERISA. This paper describes the details behind our evaluation and monitoring process, and provides an understanding of why such specialized due diligence is essential for target date strategies. Fiduciary Responsibility In 2007, the Department of Labor established target date funds as a suitable Qualified Default Investment Alternative (QDIA). This status offers plan fiduciaries the protection of a safe-harbor provision, so that sponsors are not liable for losses occurring as a result of participants being defaulted into a target date fund option within their retirement plan. However, the market turmoil in 2008 and the resulting investor losses within target date funds led to extra attention on these investment vehicles. Investors and plan sponsors have since learned that there is an alarming amount of variation in risk composition from one target date fund manager to the next. We believe that prudent selection of a target date manager must consider many factors beyond the basic intention of the strategy. These factors are explored in greater detail in this paper.

2 Target Date Fund Evaluation and Selection Target Date funds are diverse, and are therefore difficult to compare. For instance, some series are designed with a glidepath to take an investor to the year of retirement, and therefore focus on capital preservation for several years prior to retirement. The rationale for these to series is that investors face the greatest amount of risk at the retirement date, and risk actually decreases during the drawdown years since the account value is decreasing. When the target date is reached, the portfolio shifts to a conservative, static mixture so that a participant will potentially have a consistent drawdown during retirement. To the contrary, other series are designed with the philosophy that an investor is not going to remove their assets as soon as they hit that golden year. An investor still has a fairly long time horizon and can still handle some degree of risk. These strategies are designed to gradually scale down the equity exposure over 20 or 30 years post-retirement. It is imperative for a plan sponsor to understand which of these investment objectives is being followed by the chosen series. Even after filtering through the tos and throughs and comparing only the strategies with the same objective, there are still significant differences between philosophies on risk management. Some managers will choose the conservative path and dial down equity exposure early. Other managers will take into account the risk of underfunding and outliving retirement assets and will maintain an aggressive posture in their portfolios for years after retirement. Essentially, these managers are making different risk management choices, with some managers putting more emphasis on market risk, while other managers are more focused on longevity risk. The level of equity exposure built into the glidepath contributes significantly to relative performance versus peers. As in most investment planning situations, this asset allocation decision typically outweighs all other decisions made by the series management team as a driver of relative performance. Ideally, an investor s success in achieving their retirement goals would be a key component in the evaluation process. However, not only do investor goals and expectations vary greatly, these strategies are also too young to use such a metric. Even with longer history, success of one strategy over another is extremely marketdependent. We cannot know in advance if the more conservative or more aggressive glidepath will be the winner in any particular market climate. Rather than judging these strategies based on a personal opinion of the proper amount of equity exposure at each point in the glidepath, it s a good idea to compare performance to peers with similar philosophies and with the same target dates over as long of a period as possible. As with the evaluation of any active manager, historical performance should only represent a small portion of the overall evaluation process. Besides performance, many other, more qualitative factors must be taken into account. We have summarized these criteria into a scorecard which we use in the target date manager selection process. 1

3 Series Selection Scorecard We find it helpful to make relative comparisons between target date series, so we gather information from all of the prevalent series into the form of peer universes. We group the funds by target retirement year so that each fund in a series can be compared to funds with the same objective. We develop a quantitative score for each series with a range from 1 (unacceptable) to 5 (outstanding), which is a composite of seven separate segments. To arrive at the overall score, seven segments are evaluated separately on a scale of 1 to 5, and then the total score is computed as an equally weighted average. A sample of our selection scorecard is shown in Exhibit A. The seven segments are described individually below. I. Investment Methodology and Portfolio Construction Factor 1: Portfolio Construction What is the methodology used to arrive at the asset allocation? Is there sufficient diversification across asset classes and sub asset classes? Are nontraditional and lower correlated asset classes such as REITs, commodities, emerging markets and inflation-linked bonds included? Is the capitalization weighting and style orientation appropriate given the target retirement date? What is the level of overlap between the underlying funds? Construction of the portfolios within the series must be evaluated by viewing the strategies from different perspectives. The majority of series operate as funds of funds, so we view each fund as it breaks down into underlying funds. We check to see if there are any major asset overlaps. If overlaps do exist, we confirm that the asset allocation process considers these exposures and risks are being managed from an overall level by the person or group responsible for the asset allocation decisions. The next perspective to consider is a breakdown of the strategies by asset class. In the case of a series that does not use the fund of funds structure, this will be the only perspective possible. Even with the fund of funds structure, some underlying strategies may span more than one asset class, so this may result in different slices than the fund view. We feel that at a minimum, a portfolio needs exposure to the basic asset classes: Large Cap Value and Growth Mid and Small Cap Value and Growth International Equities Aggregate Bonds Global Bonds A passively managed component REITs, commodities, emerging markets, and inflation-protected bonds can significantly enhance the diversification of each portfolio, allowing for either risk reduction with equivalent return, or higher expected return with equivalent risk. Some managers of collective trust series may include a stable value component in place of cash which has the advantage of adding to portfolio stability with a higher 2

4 return expectation than a money market strategy. Some managers may also use derivatives to provide some downside protection, or as a way to limit or obtain exposure to equity markets. The additional cost and liquidity risk must be evaluated when considering the use of these tools. Also of note is whether or not the manager employs a tactical allocation strategy within the series. Tactical allocation, which allows managers the freedom to search for the best opportunities across asset classes, has the potential to drive up expenses and leads to unpredictable results. We believe a modest allowance for tactical management is acceptable, but for the bulk of the portfolio, it s more appropriate to employ a long-term strategic allocation philosophy when dealing with retirement savings. In addition to utilizing a wide breadth of asset classes, the portfolio construction needs to be appropriate for the risk tolerance level based on the time remaining to the target date. Although this decision requires some subjectivity from the management team, portfolio construction still needs to follow certain patterns. For instance, our research shows that the value style of investing is generally less risky than growth, large caps are less risky than small caps, and developed international markets are less risky than emerging markets. Therefore, we like to see that we can detect a shift from the risky assets to their less risky counterparts as the target date nears. Factor 2: Manager Selection Does the provider use an objective approach in selecting best-in-class managers, or is there a proprietary bias? Is the process for selecting and monitoring the underlying managers well defined and adhered to on a consistent basis? What is the quality of the underlying holdings? To what extent have these offerings provided competitive returns? Most series employ a closed architecture, where underlying strategies are chosen exclusively from the same fund family. The main motivation of this approach is that the advisor retains all of the funds management fees. In some cases, the benefits of fee retention are seen by investors in the form of expense savings. As further justification to this approach, the management team has more knowledge of their own in-house strategies than those managed externally. And to some extent, the management team may have some input or control over the mandates of in-house underlying strategies. However, there is a danger that the target date fund series may be used to promote inferior managers by increasing their assets under management. In the case of a closed architecture, it s important to evaluate whether the series management is using an objective selection criteria or a biased approach. We examine the asset allocation to underlying strategies very closely. Do all of the assignments make sense from a diversification standpoint, or is there a substantial overlap in investment styles and objectives? If low-quality managers are being utilized, are better options available within the fund family? 3

5 In the Manager Selection category, we tend to give higher scores to providers who use an open architecture approach, where the manager can seek best-in-class strategies from any organization. This flexible mandate eliminates single-firm risk and brings a wider variety of management approaches and ideas to the table, resulting in a higher overall level of diversification. The Manager Selection criterion also include an assessment of the quality of the due diligence from the top level, asset allocation management, since this team must have the resources to track each manager closely and implement changes when necessary. For a fiduciary, some analysis of the underlying strategies is prudent to properly evaluate the series. For instance, is a strategy with a recent management change being closely monitored? Are low-quality strategies being held for too long? And equally damaging, are highquality strategies being replaced too quickly due to short-term performance blips? Factor 3: Glidepath/Risk Management What is the methodology by which the asset allocation is adjusted over time? Is the percentage of equities in the glidepath appropriate given the targeted retirement date? Is there an appropriate balance between maximizing long-term growth and managing risk? It is critical to gain comfort that the management team has a well thought-out process for constructing the glidepath. Preferably, the glidepath construction is based on modeling and scenario testing and is supported by a robust asset allocation framework. Judging the appropriate level of equities is challenging because those who stray from the norm could be the most successful in retrospect. It s not advisable to score a series low due to a deviation from the average peer in terms of risk philosophy, because target date managers take vastly different approaches to balancing the risks of longevity and markets. However, if the management team is taking an extreme stance on risk positioning and giving considerably more priority to either longevity risk or market risk, this decision should result in a lower score for the series in this category. The variance from peers adds some uncertainty and risk to the plan sponsor which should be accounted for in the scoring criteria. II. Organizational Strengths Factor 4: Manager Experience How long has the firm been managing lifecycle funds? What are the assets under management in the series? What are the average industry experience and tenure of the investment professionals responsible for managing the series? Are there sufficient resources available to assist in this process? These questions all characterize the expertise of the management team in performing this type of analysis. Investors want to rely on a seasoned group of professionals with a proven track record in asset allocation decisions and managing retirement savings. In our practice, we score this criterion on a relative basis by comparing assets under management, tenure, and resource availability to the other target date series in our peer group. 4

6 III. Quantitative Measures Factor 5: Expenses Is the fund s annual expense ratio below the median for its peer group? Are the expenses reasonable given the investment strategy (i.e. active versus passive, tactical asset allocation versus strategic)? We compare the average expense ratio of a series to our peer group. Our peer group is broken into quintiles, and a manager s score is implied by its quintile. For example, if the fund s expense ratio is in the 60-80% quintile, the series scores a 4. To judge the reasonableness of the expense ratio, we also qualitatively consider whether the underlying strategies are actively managed or index funds. We also take into account whether the target allocations are tactical or strategic. Another consideration is whether or not the structure is based on proprietary management versus open-architecture. An open-architecture approach may justify higher expense ratios because of the greater role due diligence plays in the process, and because the asset allocation function is less likely to be paid from underlying fund management fees. Our overall expenses score is computed as the average of the rankingsbased and qualitative scores. Factor 6: Up/Down Market Capture To what extent has the fund outperformed its appropriate benchmark in rising markets? How effective has the strategy been in protecting capital in market downturns? We convert these two questions into a single metric by dividing the up market capture by the down market capture. The value is compared to peers, and the final score for this criterion is based on the fund s quintile. Factor 7: Risk-Adjusted Returns/Sharpe Ratio Has the fund outperformed its appropriate benchmark or peer group on a risk-adjusted basis for the trailing 60-month period? Although target date fund strategies are still fairly new to the investment world, most have accumulated enough historical performance data to be compared on a 60-month basis. While it is prudent to analyze performance on as long of a timeframe as possible, our process focuses on a 60-month timeframe so that we can evaluate strategies against a reasonably-sized peer group. This score is computed as excess return over 60-months divided by standard deviation, and then compared to the quintile rank versus peers. Quarterly Monitoring Scorecard and Beyond Even after a thorough evaluation and selection of a target date series, quarterly monitoring is necessary to ensure the series continues to meet the standards of a plan fiduciary. We evaluate each target date series held by our clients on a quarterly basis. Unlike the selection criteria where scores can range from 1 to 5, our monitoring scorecard is a collection of pass/fail scores. A brief explanation of the monitoring criteria is detailed below: Risk-Adjusted Performance on Income Fund On a risk-adjusted basis, has the Income Fund outperformed its peer group over the last 60 months? 5

7 This criterion is meant to measure performance at the conservative end of the risk spectrum, and may be replaced by a 2010 fund or similar strategy in cases where an Income fund does not exist or is not representative of a conservative allocation. We believe that measuring performance against peers on a riskadjusted basis helps to account for variations in glide paths. Risk-Adjusted Performance on 2040 Fund On a risk-adjusted basis, has the 2040 fund outperformed its peer group over the last 60 months? The 2040 Fund is typically chosen to represent the more aggressive end of the risk spectrum, since longer dated strategies tend to be newer and will not yet have sufficient history to satisfy our 60-month monitoring period. Expenses Is the series average annual expense ratio below the median for the peer group? Are the expenses reasonable given the investment strategy (active versus passive, tactical asset allocation versus strategic)? Expenses are examined at selection, and re-visited relative to peers on a quarterly basis. For expenses and other quantitative criteria, we use the same peer groups we developed during the target date selection process. Glidepath Stability Are the asset class weightings appropriate given the manager s target and does an appropriate balance exist between maximizing long term growth and managing risk? Have there been minimal changes to the glidepath structure in recent history? Many target date managers have made changes to their glide paths. If changes are substantial, a series would fail the stability criterion which would trigger close monitoring and discussions with the management team. The review with management gives us a chance to understand their perspective and glide path review process. The impact the new glide path will have on suitability for existing clients will also be taken into consideration. Manager and Organizational Stability Have the portfolio management team and firm been stable for the last 12 months? Have any changes occurred to the firm s ownership, control or management? Is the firm subject to any regulatory action, investigation or litigation by a government agency? Management changes must be considered just as they are for all strategies, however, it should be noted that for the funds-of-funds structure, there are two management levels. If there is significant turnover within management of the underlying strategies, the size of the allocations must be taken into account to determine their true impact on the total portfolio. Similarly, the top level management team controls the asset allocation decisions and performs underlying manager due diligence, so this team must be monitored for management continuity as well. If a series passes fewer than four criteria, it is placed on our Watch List, and must resume passing at least four criteria in the subsequent eight-quarter period to be removed from the Watch List. If a series fails to improve its score, we would issue a replacement recommendation. Of course, there are circumstances where we will recommend replacement without the eight-quarter waiting period if we have good reason to expect that a series has been permanently impaired. There are also times when a series may join the Watch List even with a score above 3. Exhibit B demonstrates our standard quarterly scorecard. 6

8 In addition to providing quarterly scores, it is important for plan sponsors to remain aware of any risks inherent in the series they have chosen for their plans participants. For instance, the T. Rowe Price Retirement series is known to be on the aggressive side when compared to their peers when it comes to the equity exposure taken at each point along the glidepath, in particular near retirement. We demonstrate this risk by including a chart within our clients quarterly reports that compares equity exposure to its peers at select points along the glidepath (see Exhibit C). In addition, we include quarterly commentary that highlights any changes made to the management team or process, asset allocation, or underlying strategies over the course of the quarter. Conclusion Asset allocation strategies can play an important role in a defined contribution retirement plan menu and can provide extra security to plan participants in the form of professional investment advice. Indeed, we believe that the majority of participants are best served by investing in target-date or risk-based asset allocation funds, as they are less likely to chase the performance of the most recently hot asset class or style. For plan sponsors, however, evaluating and monitoring asset allocation portfolios and target-date series in particular carries special challenges. We believe that the prudent process we have developed for the evaluation and monitoring of target-date series ensures a high quality investment selection for participants while minimizing fiduciary liability for plan sponsors. For More Information For more information about plan solutions provided by The Newport Group, please contact: Amy K. Parker, AIF Managing Director, Investment and Fiduciary Consulting The Newport Group 300 International Parkway Suite 270 Heathrow, FL amy.parker@newportgroup.com 7

9 Exhibit A: Sample Selection Scorecard Scoring Criteria I. Investment Methodology in Constructing the Funds Portfolio Construction What is the methodology used to arrive at the asset allocation? Is there sufficient diversification across asset classes and sub asset classes? Are nontraditional and lower correlated asset classes such as REITs, commodities, emerging markets and real return bonds included? Is the capitalization weighting and style orientation appropriate given the target retirement date? What is the level of overlap between the underlying funds? Manager Selection Does the provider use an objective approach in selecting multiple, best in class managers, or is there a proprietary bias? Is the process for selecting and monitoring the underlying managers well defined and adhered to on a consistent basis? What is the quality of the underlying holdings? If proprietary funds are used, to what extent have these offerings provided competitive returns across a number of asset classes and styles? Glide Path/Risk Management What is the methodology by which the asset allocation is adjusted over time? Is the percentage of equities in the glide path appropriate given the targeted retirement date? Is there an appropriate balance between maximizing long-term growth and managing risk? How frequently are the portfolios rebalanced to the targeted allocations? Score II. Organizational Strengths Manager Experience How long has the firm been managing lifecycle funds? What are the assets under management in the series? What is the average industry experience and tenure of the investment professionals responsible for managing the series? Are there sufficient resources available to assist in this process? 4.8 III. Fund Expenses Is the fund s annual expense ratio below the average for its peer group? Are the expenses reasonable given the investment strategy (active versus passive; tactical asset allocation versus strategic)? 4.3 IV. Performance Up/Down Market Capture To what extent has the fund outperformed its appropriate benchmark in rising markets? How effective has the strategy been in protecting capital in market downturns? Risk-Adjusted Returns Has the fund outperformed its appropriate benchmark or peer group on a riskadjusted basis for the trailing 60-month period? Overall Score: 4.2 Target Date Fund Series are evaluated based on the following criteria Portfolio Construction, Manager Selection, Glide Path/Risk Management, Manager Experience, Expenses, Up/Down Market Capture and Risk-Adjusted Returns. Each of these measures will be rated on a scale of 1 to 5, and the cumulative score will then be averaged to determine a total score as defined as follows: Scoring Key 5 = Outstanding 4 = Very Good 3 = Average 2 = Needs Improvement 1 = Unacceptable *The sample evaluation scorecard is for example purposes only and should not be utilized or relied upon for any other purpose. 8

10 INVESTMENT CONSULTING PHILOSOPHY AND PROCESS QIMR Executive Summary Asset Allocation Exhibit B: Quarterly Scorecard If any manager fails two (2) or more of the five (5) criteria, the fund will be placed on the Watchlist. Source: Newport Group Exhibit C: Glidepath Comparison Chart 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Equity Allocation along the Glide Path 30 Years Before Retirement 20 Years Before Retirement 10 Years Before Retirement At Retirement Source: Newport Group, Morningstar 9

11 About The Newport Group Founded in 1984, The Newport Group is a leading financial services firm specializing in the creative design and administration of retirement and executive benefit plans, as well as investment and fiduciary consulting services. Through its innovative and customized solutions, Newport is uniquely positioned to satisfy the distinct financial needs of employers and employees, and has done so for hundreds of the country s largest and best-known companies. 10

12 300 International Parkway, Suite 270 Heathrow, Florida p f IMPORTANT INFORMATION For Institutional Investors Only. Not intended for redistribution or public use. Newport Group Securities, Inc. (d/b/a The Newport Group) is dually registered as a registered investment advisor and broker-dealer, and Member FINRA ( 300 International Parkway, Suite 270 Heathrow, Florida All investment consulting services are provided through its registered investment advisor while all securities transactions are provided through the broker-dealer. The Newport Group, Inc., Newport Retirement Services, Inc., and Newport Group Securities, Inc. are affiliated entities. For more information about our services, please visit or refer to our Form ADV Part 2, which is available by contacting us at The format and substance of the material contained in this report were developed by and constitute the confidential work product of The Newport Group. Any discussions concerning investments should not be considered a solicitation or recommendation by Newport Group Securities, Inc. This presentation is being provided for informational purposes only. Any information presented in connection with this communication is general in nature and is not intended to provide personal investment advice and is not intended to be used as the sole basis for any investment decision. Prior to making any investment decision, an investor should independently evaluate the relevant risks involved and ensure that such investment is appropriate and suitable for the investor in light of their investment objectives, trading experience, time horizon, financial resources, risk tolerance and other relevant circumstances. Past performance is no guarantee of future results. The information contained in this report has been compiled from sources believed to be reliable, but no representation or warranty, either express or implied is made by Newport or any person as to its accuracy, completeness or correctness. All opinions and estimates contained herein constitute judgment as of the date of this report and are subject to change without notice. This report may not be reproduced, distributed or published in whole or in part by any recipient hereof for any purpose IA-14 FOR PLAN SPONSOR AND FINANCIAL PROFESSIONAL USE ONLY. NOT FOR USE WITH THE PUBLIC THE NEWPORT GROUP