Navigating the Target Date Fund Evaluation Process

Transcription

1 Navigating the Target Date Fund Evaluation Process A Primer for Retirement Plan Sponsors Benjamin J. Smith, CFA Principal, Chief Investment Officer

2 Contents Introduction. Understanding the Core Attributes of the Target Date Fund Suite... Analyzing the Glide Path & Investments of the Target Date Fund Suite Analyzing whether a custom or non-proprietary TDF is a better fit Guidance Point Retirement Services Evaluation of Target Date Funds... About Guidance Point & Disclosures

3 Introduction 1

4 The shift from defined benefit to defined contribution plans over the past 40 years has resulted in employees taking on more responsibility for their own retirement outcomes. It has also meant that professional investment decisions have increasingly been replaced by the non-professional investment decisions of plan participants, who are typically inexperienced, prone to counterproductive behaviors, and in need of general assistance. Recently, retirement plan fiduciaries have sought to insert professional investment decisions back into defined contribution plans through the offering of Target Date Retirement Funds (TDFs). A Target Date Fund is defined as a mutual fund in the hybrid category that automatically resets the asset mix of stocks, bonds and cash equivalents in its portfolio according to a selected time frame that is appropriate for a particular investor. A Target Date Fund is similar to a life-cycle or fixed asset allocated fund except that a Target Date Fund changes its allocation between stocks and bonds over time until some date in the future, such as retirement. Its returns are not guaranteed, but depend on how the market performs. 1 The target date refers to a retirement date in the future, and many times the retirement year is included in the name of the mutual fund. The purpose of this paper is to assist retirement plan fiduciaries evaluate Target Date Retirement Funds. TDF strategies have become very popular since the Pension Protection Act of 2006 confirmed that TDFs could be included as a qualified default investment in retirement plans, or the Qualified Default Investment Account (QDIA). Therefore, plan sponsors could add TDFs to their retirement plans and designate them as a QDIA while enjoying fiduciary safe harbor protection as discussed in Field Assistance Bulletin No Guidance Regarding Qualified Investment Alternatives (29 CFR c-5). It s estimated today that approximately 31% of dollars that enter retirement plans ultimately are invested in a target date fund investment strategy. Due to the increasing popularity of target date fund strategies in retirement plans, in 2013 the Department of Labor (DOL) published Target Date Retirement Funds Tips for ERISA Plan Fiduciaries. The full list of tips included is found here: Introduction 2

5 Introduction 3 Key points from this document that fiduciaries should keep in mind when selecting and monitoring TDFs are: Establish a process for comparing, selecting, and periodically reviewing the TDFs. Understand the asset allocations, glide paths and expenses of the funds and compare them to other Target Date Fund strategies. Consider their participant demographics, participation, salary levels, turnover rates, contribution rates and withdrawal patterns. The discussion on the following pages explains how Guidance Point analyzes TDF products. It is also intended to address the first four bullets listed above. The last two bullet points should be considered with your retirement plan committee and your plan consultant. The fact that the Department of Labor is issuing a memo to plan fiduciaries on this topic indicates there is a gap between what the DOL expects plan fiduciaries to do and what level of review plan fiduciaries are actually taking. Inquire whether a custom or non-proprietary TDF would be a better fit. Develop effective employee communications. And lastly, make sure to document your process.

6 4 Understanding the Core Attributes of the Target Date Fund Suite

7 Understanding the Core Attributes of the Target Date Fund Suite 5 1) Firm, Process, and People A proper, and perhaps most important starting point for analyzing a Target Date Fund (TDF) suite is to assess the core competencies of the parent firm and management team. Many fund companies have spent decades developing competencies related to building an investment management strategy within a particular asset class, management style and/or sector. Target Date Funds are different in that the firm now has an additional layer of responsibility in managing a portfolio of managers and selecting an appropriate asset allocation of the fund series for investors over a period of 75+ years. Due to the complexity of Target Date Funds and the importance they currently play in defined contribution plan design, plan sponsors should be diligent in their process to assess the experience of the firm in managing global asset allocated portfolios at varying risk levels. Since TDFs are actually funds of funds with an asset allocation overlay, they should be treated like any other fund in their retirement plan menu. Fiduciaries should also be cautious about replacing their TDF series every few years since effective participant communication relative to the assumptions and nature of the selected TDF is a key bullet in the 2013 DOL TDF Bulletin. Therefore, a plan sponsor should evaluate the following: The investment firm s commitment to their TDF series The depth of the research and investment management team overseeing the TDF strategy Other funds outside of the TDF that are managed by the TDF manager How often managers have been replaced within the TDF series since inception The investment management firm s commitment to maintaining the construction process of the TDF glide path

8 Understanding the Core Attributes of the Target Date Fund Suite 6 Since these funds have become a core Qualified Default Investment Account (QDIA) option in retirement plans, over 30% of all retirement plan dollars are currently purchasing Target Date Funds. Most mutual fund companies have developed some sort of strategy to meet the demand for TDFs. The funds have evolved fairly rapidly as fund companies attempt to develop their own brand and differentiate from their competitors. Additionally, legislative pressures following the equity bear market have caused shifts in how many TDF series have been invested and marketed. Even though these types of products are still in their infancy, there has been a proliferation of mutual fund products that have been created. Our firm expects to see these funds change over time in reaction to further industry innovations, participant expectations, and changing global capital markets. Upon selection of a TDF series for a retirement plan, fiduciaries need to implement an ongoing review process. 2) Identify Unique Fund Membership of the TDF Suite The next step in analyzing a TDF series is to identify the membership of each unique fund in the series. This may include a retirement date fund for every decade while others may segment to every five-year period. Additionally, there may be funds in the series with retirement dates that have already occurred relative to today s date, while other fund families will withdraw a fund once the retirement date has occurred. This will be discussed further in the Analyzing the Glide Path and Investments of the Target Date Fund Suite section of this paper. Lastly, some fund suites include an income fund that simply mirrors the resting asset allocation of the TDF glide path.

9 Understanding the Core Attributes of the Target Date Fund Suite 7 3) Understand the Expense Ratio of the Funds One qualitative factor to consider is the total expense of the fund suite involved. Since Target Date Funds essentially own other mutual funds (otherwise known as a fund of funds or manager of managers), it is important to know if the suite is charging an overlay fund fee for oversight of the glide path asset allocation. In 2012, 34 out of 48 (71%) fund series had an overlay fee. Similarly, 34 out of 50 (68%) fund series had an overlay fee in This point is important as high fees tend to correlate to lower returns over time. The average asset weighted expense ratio for TDFs in 2012 was 0.91%. 3 As fiduciaries, having an ability to compare or benchmark the fees of the particular fund series is a critical step. Either through direct communication with the fund company and/or through their literature, we recommend examining the philosophy behind the fee being assessed by the fund. Does the fund justify a higher cost due to a perceived advantage such as a deeper research analyst team or systems that give the fund manager a lead? Are the fees more expensive because of the inherent fixed costs required to run their mutual fund? As the TDF series attracts more assets, will the fee be expected to decrease? These are a few questions to explore when understanding the costs of Target Date Funds Morningstar Target-Date Series Research Paper 2013 Survey page 2 9

10 Understanding the Core Attributes of the Target Date Fund Suite 8 4) What is the Architecture of the Fund Series? Generally when referring to a fund of funds manager, it s important to consider whether the manager has an open or closed architecture relative to the construction of the fund. This question essentially refers to whether the fund company utilizes funds from outside of their own company (open) or only exclusively uses their own parent company s funds (closed) to fulfill their asset allocation strategy. At the end of 2012, only 9 of the 48 series had a purely open architecture 4. In an absolute sense, an open architecture TDF may be preferable since each fund company within the asset allocation has strengths and weaknesses in management of particular asset classes. However, this may mean that the TDF series manager will have to charge an overlay fee to compensate for their work. 5) Are there any investor restrictions? Investor restrictions are features used by the fund company to protect the investment strategy from investors redemption and admission activity. Generally, these are seen in a couple of different ways including roundtrip provisions and short-term redemption fees. Roundtrip provisions restrict investors from selling their position in the fund, and then buying back a short time later. This restriction is a time restriction, but does not cost the investor any dollars. This attempts to dissuade the investor from trying to market time with these types of funds. 4 Morningstar Target-Date Series Research Paper 2013 Survey page 69, Appendix 3

11 Understanding the Core Attributes of the Target Date Fund Suite 9 Short-term redemption fees act in a similar fashion as the roundtrip provisions, but impose a fee to investors to dissuade them from timing activities. Usually, these fees are in place for a period of time after sale, and costs range in percentage terms. Plan sponsors should be aware of these impacts especially if they are considering a TDF series with a short-term redemption fee as a Qualified Default Investment Account (QDIA) and automatically investing participants into these funds. If the participant processes a rollover into the plan without updating their investment elections, and then opts to change their investment allocations, the fee impact could be significant to the participant. 6) Assess the growth and Assets Under Management (AUM) of the funds Another important factor is the growth of the TDF series being analyzed. What has been the trend in the TDF series attracting assets? Has the fund series become more popular or less? What is the strategy of the fund series if they attract too many assets? At what point would the fund series close if they don t attract enough assets? Also, it is important to note the size of each particular fund in the series in relation to the assets of the retirement plan. This could be a problem, for example, if a particular vintage of the series only has $40 million in the fund, and your retirement plan is looking to map in $20 million into that fund. The plan sponsor should have a clear understanding of how the fund company will handle admissions and redemptions. If the plan is a large investor in a particular fund or series, the Committee should consider possible liquidity constraints of participants if they decide to shift their allocations out of the TDF series. 11

12 10 Analyzing the Glide Path & Investments of the Target Date Fund Suite

13 Analyzing the Glide Path & Investments of the Target Date Fund Suite 11 1) To versus Through Glide Paths The term glide path when discussing Target Date Funds refers to the extent of how the series derisks the asset allocated portfolio by increasing the bond allocation during the course of a participant s career. There are very different investment philosophies that have taken shape over the course of the past decade when managing the glide path. To glide paths de-risk, or increase the fixed income exposure of the portfolio until an assumed retirement age of 65 when the Target Date Fund series then ends up at its most conservative point. Through glide paths derisk the portfolio past the age of 65 and reach their most conservative point at some date after 65. The Through portfolios offer an additional analytical step of evaluating when the portfolio reaches its resting place. Is it 5 years after retirement? 20 years? 30 years? As glide paths determine the asset allocation of the portfolios over time, this will make comparing each Target Date Fund series difficult as performance and risk of the funds will vary with each differing glide path. This nuance has caused the DOL to require plan sponsors offering these funds as a QDIA to annually document to participants the glide path and composition of each fund over time. So which one is better? The retirement plan or investment management industries have not come to a conclusion on which one is preferable. The trade-off analysis that the plan sponsor must undertake is between adopting more longevity risk or more market risk. By adopting a To glide path, a retirement plan committee and participant may gain more peace of mind that their balances fluctuate less on a yearly basis than if the glide path maintained a more aggressive allocation over time. However, the participant ultimately sacrifices potential higher returns and sustains a larger chance of out-living their retirement savings.

14 Analyzing the Glide Path & Investments of the Target Date Fund Suite 12 Plan sponsors may want to take into account mortality considerations for their work force in assessing which risk is more appropriate to take. If much of your work force has a low retirement savings balance and a long life expectancy, a Through glide path may be more appropriate. The retirement plan committee should keep in mind their participant demographics (including participation, salary levels, turnover rates, contribution rates and withdrawal patterns) when determining which glide path is most appropriate. As an example, the chart to the right demonstrates the change in the overall asset allocation during the investors time horizon. The table below demonstrates the actual weightings of major asset classes in each Target Date Fund year. In this particular series, the equity allocation doesn t reach its minimum standing until 7 years into retirement, thus this series would classify as a Through series. TARGET DATE ASSET ALLOCATION as of: 08/31/2014 Asset Exposure, % Income Equities Bonds Cash Other Income Equities Bonds Cash Other

15 Analyzing the Glide Path & Investments of the Target Date Fund Suite 13 2) Glide Path Stability Unfortunately, a constant shifting of the TDF glide path produces a large analytical issue. Changing of the glide path is problematic to investors as they do their initial review of Target Date Funds and decide which series best follows their own philosophies towards retirement. For an investor, plan sponsor or investment fiduciary, it is very frustrating to conduct a review of a Target Date Fund strategy/assumptions and then to have the funds assumptions change after the decision-making process is concluded. A fundamental change in belief system for a Target Date Fund series may leave current investors with a different asset allocation at various points along the glide path than intended. In 2011, Morningstar analyzed glide paths in the TDF industry and titled their report Bait and Switch: Glide Path Instability. The changing assumptions that a Target Date Fund series may make over time may cause issues with the stability of their glide path for investors. You can see the year-by-year changes of the above fund glide path. Note that due to manager and investment philosophy changes, the above fund has changed again as of 2014 to include more equity in the glide path. It is important for investors to note whether a glide path is deemed stable or not. Instability of the glide path should serve as a red flag for a series.

16 Analyzing the Glide Path & Investments of the Target Date Fund Suite 14 3) What is the strategic and tactical investment philosophy of the TDF manager? What is the Asset Allocation? The investment philosophy of the TDF manager is important as one should consider this in concert with how the fiduciaries are designing their overall retirement plan menu for plan participants. Does the TDF manager utilize an active investment management approach or does the TDF manager subscribe to a passive management philosophy where one believes it s not possible to outperform the market and attempts to mimic the underlying index benchmark? The Active and Passive philosophies can be extended not only to the underlying managers fulfilling their mandate for particular asset classes, but also to active tactical decisions by attempting to add value by overweighting asset classes based on the TDF manager s future predictions. Does the TDF manager make strategic shifts to the TDF glide path over time? These considerations are important when evaluating how a TDF is constructed and invested over time. After assessing the glide path, the next logical step is to understand how the investment manager goes about investing along the glide path through asset allocation. What asset classes are to be included in the overall asset allocation? Do the capital market assumptions of the investment manager drive the selection of specific asset classes? Depending on how these questions are answered, the investment manager will then decide what combination of asset classes become included or excluded at differing points along the glide path to maximize return and minimize risk for the portfolio. 16

17 Analyzing the Glide Path & Investments of the Target Date Fund Suite 15 4) Performance Assessment Unlike the assessment process of style and philosophy for specific investment managers, surprisingly, previous performance of the TDF suite isn t a major consideration in selection of a Target Date Fund manager. All of the qualitative and quantitative factors discussed previously will have an impact on the performance of the series. As all TDF series will have differing assumptions, asset allocations, and glide path strategies, simply choosing a TDF series based on relative performance will ignore many important factors that drive the overall success of a TDF. An alternative to overseeing the performance of the Target Date Fund series is to assess the chosen investment vehicles that are to fulfill the asset allocation mandate of the glide path. To measure the underlying funds quality, a plan sponsor could utilize their own screening methodology used to oversee other investment options in the plan against the underlying investments chosen by the investment manager. If a plan sponsor s screening methodology would not look favorably on the individual investment options used in the TDF asset allocation, then perhaps the plan sponsor should consider not using the TDF series. Another performance related area that plan sponsors can assess is whether or not the underlying funds have consistently changed. It is important to hear from the asset allocation manager why underlying fund changes have been made and whether this is a positive or negative development.

18 16 Analyzing Whether a Custom or Non-proprietary TDF is a Better Fit 5 5 Perspectives on custom target date strategies in DC plans, Vanguard Group, March 2014

19 Analyzing Whether a Custom or Non-proprietary TDF is a Better Fit 5 17 After performing the previous set of analysis of proprietary (off the shelf) Target Date Funds, a retirement plan fiduciary may find that there isn t a fund series that matches the goals and philosophies of their particular demographic. In particular, the fiduciaries may want their TDF strategy to more closely reflect their unique investment beliefs, or they may want a custom glide path that s based on their participants characteristics, or they may prefer more direct control over their plan s investment strategy. Plan fiduciaries are urged to consider how their view of retirement plan investing differs from what is available through standard TDFs, and whether the differences are large enough to consider building a custom option. Implementing a custom TDF strategy presents additional tradeoffs between benefits and costs. The perceived benefits previously listed are now to be weighed against increased oversight responsibility, an administrative burden to manage the funds, and the implicit / explicit costs of the offering. The adoption of a Target Date Fund is a fiduciary act, and the responsibilities of oversight exist whether the offering is proprietary or customized. Plan sponsors must realize that they will now be taking some or all of the direct fiduciary responsibility for investment process that results from selecting a customized offering. If this responsibility is outsourced, then the sponsor remains liable for the prudent selection and oversight of the investment manager and the chosen glide path. Actual performance (not back tested or hypothetical) should be compared against a custom benchmark comprised of indexes to properly assess weighting and timing decisions of the manager relative to holdings and the glide path.

20 Analyzing Whether a Custom or Non-proprietary TDF is a Better Fit 5 18 Costs are always an important evaluation point when requesting custom work of any type. Costs may be apparent for items such as glide path design, investment management services, investment administration services, participant communication, and/or consultant fees. Custom strategies are more likely to bear higher costs than proprietary offerings, and the plan sponsor should consider the probable drag on performance results. To fully compare the custom Target Date Fund offerings, the plan fiduciaries should consider evaluating the expected outcomes of the custom TDF relative to a passively managed, or indexed, alternative. The fiduciaries should look for sustained benefits of the custom offering, sustained manager skill in delivering the benefits, and whether the fund series can overcome the direct and indirect cost of implementation. The plan sponsor will need to be able to judge whether the benefits outweigh the costs of the custom TDF.

21 19 Guidance Point Retirement Services Evaluation of Target Date Funds

22 Guidance Point Retirement Services Evaluation of Target Date Funds 20 Guidance Point Retirement Services research continues to favor the usage of Target Date Funds within defined contribution plans. Target Date Funds allow for retirement plan participants to receive professional money management that de-risks their retirement portfolio over their career. The majority of retirement plan participants are unwilling or unqualified to create diversified portfolios and appropriately de-risk their market risk exposures over time. Admittedly, there are no perfect solutions as the Target Date Fund structure forces each participant to conform their risk tolerances, investment strategy, and de-risking strategy to the TDF philosophy. It is our opinion that there is no one best glide path, investment provider, asset allocation, or de-risking strategy for plan sponsors to select for their retirement plan. In respect to the Department of Labor auditing plans, the best way for a plan sponsor to comply with the 2013 DOL bulletin is to create a diligent process in selecting and monitoring a Target Date Fund series and then document the process and results. In our experience, many small and mid-size retirement plan sponsors do not have a documented process related to the selection of their selected Target Date Fund series provider. We believe that by creating such a process and performing a deep analysis covered by the steps outlined in this paper, plan fiduciaries can create better participant retirement outcomes. Absent this type of analysis, fiduciaries that utilize only traditional performance screening techniques for Target Date Fund selection may impede retirement outcomes in a world where participants face formidable retirement impediments already.

23 About Guidance Point Retirement Services 21 Guidance Point Retirement Services, LLC. is a provider of independent fee-only retirement plan and investment consulting services to corporate and tax-exempt organizations. The firm was founded to provide fiduciary consulting services to plan sponsors as they face increased regulatory scrutiny and vendor complexity. When providing ongoing investment consulting services, Guidance Point serves as a co-fiduciary or named fiduciary. Guidance Point is designed to address all aspects of fiduciary duty, plan selection, implementation and operation. Please visit guidancepointrs.com for more information. Disclosures This Ebook is not intended to be completely comprehensive or provide complete information on each subject included. You should contact your legal and/or financial advisor for further and additional information if necessary. Investment performance and returns are based on historical information and should not be construed as a guarantee of future performance. Investing contains risk. Some of the asset classes involve significantly higher risk because of the nature of the investments and the low liquidity/high volatility of the securities. Guidance Point Retirement Services, LLC. does not warrant that the information contained in this presentation is completely accurate. Guidance Point Retirement Services, LLC. has made every reasonable effort to ensure that the data utilized and the information reported is factual. If you have any questions about the calculations or numbers provided please contact Guidance Point Retirement Services, LLC. for verification. Investment advisory services provided by Guidance Point Retirement Services, LLC.