Are You in the Wrong Target-Date Fund?

Insights August 2014 Are You in the Wrong Target-Date Fund? Now Is a Good Time to Reevaluate TDFs may have different investment strategies, glide paths, and investment-related fees. Because these differences can significantly affect the way a TDF performs, it is important that fiduciaries understand these differences when selecting a TDF as an investment option for their plan. U.S. Department of Labor: Target-Date Retirement Funds Tips for ERISA Plan Fiduciaries It is an opportune time for defined contribution (DC) plan sponsors to take another look at the target-date fund (TDF) offerings in their plan lineups. TDF assets have grown significantly in recent years, with 86% of DC plans now using TDFs as their default investment option (Figure 1). The investment management industry has responded to TDF asset growth with design changes, improved delivery capabilities and increasingly competitive pricing. At the same time, the benefits of custom TDF solutions have been gaining attention and have enhanced the TDF opportunity set. This evolution means that even plan sponsors that selected their TDF options only a few years ago could benefit from reviewing today s TDF product landscape and implementation opportunities relative to their DC plan objectives to identify the most suitable TDF alternative. Equally important, the U.S. Department of Labor (DOL) signaled its heightened focus on TDFs in February 2013, when it issued general guidance confirming that plan fiduciaries are responsible for periodically reviewing TDFs, just as they are for all other investment options in their DC plans. The great appeal of TDFs is in their simplicity for plan participants, for whom they offer an easy, effective way to achieve a well-diversified portfolio focused on a timeline to retirement. For plan sponsors, TDFs can be the foundation of a streamlined, easy-to-explain investment lineup for the plan, which hopefully leads to higher participation rates, improved asset allocations for participants and better retirement outcomes. For plan sponsors, TDFs can be the foundation of a streamlined, easy-to-explain investment lineup for the plan, which hopefully leads to higher participation rates, improved asset allocations for participants and better retirement outcomes. Figure 1. Continued shift toward the use of TDFs as a default investment option Default Investment Option 2009 2010 2012 2014 TDF or life-cycle fund 64% 73% 81% 86% Balanced or lifestyle fund 22% 13% 9% 5% Stable value fund 7% 6% 3% 3% Money market fund 4% 2% 1% 2% Managed account service 1% 4% 2% 3% Do not have a default option N/A N/A 3% 2% Other 3% 3% 1% 1% Source: Towers Watson 2014 Defined Contribuion Plan Sponsor Survey, U.S.

While we see TDFs as a significant step forward in the evolution of DC plan design, they do bring increased governance complexity of which many plan sponsors may not even be aware. Most plan sponsors are familiar with single-asset-class investment options, such as equity and bond funds, which are relatively easy to understand, select and monitor for continued appropriateness as a plan investment choice. However, TDFs are more complex due to their investment in multiple asset classes and shifting asset allocations over time, commonly referred to as the glide path. This complexity leaves many plan sponsors uncertain about how to approach TDF decisions. With our experience researching and advising clients on the use of TDFs since the early days of this asset class, Towers Watson is well positioned to guide plan sponsors in making these complex decisions. Growth of TDFs The Pension Protection Act (PPA), signed into U.S. law in 2006, included a directive from the DOL to issue regulations regarding the selection of default investments by plan sponsors. The DOL s final regulations provided guidelines for the identification of an appropriate qualified default investment alternative (QDIA) to serve plan participants who decline to direct their own investments. Some plan sponsors elected to offer a balanced fund or managed account service, or to maintain a capital preservation option for a period of time. But the majority chose to offer a TDF or lifecycle fund. Findings of Towers Watson s 2014 Defined Contribution Plan Sponsor Survey in the U.S. show a continuing shift toward the use of TDFs as the default investment option (Figure 1, page 1). TDFs (see sidebar below). Although the DOL s tips are not characterized as mandatory, they do provide a comprehensive framework for evaluating TDFs that plan sponsors are using or considering for a DC plan. For many plan sponsors, the issuance of these tips served as a call to review their existing TDF selection. Unfortunately, many sponsors are unsure of the appropriate steps to take. What Is a Plan Fiduciary to Do? To answer this question, the plan fiduciary should first be clear on its reason for using the chosen option. Also, plan fiduciaries should be aware of the DOL guidance and use it as a benchmark when evaluating TDF alternatives. Many DC plans adopted the TDFs affiliated with their plan recordkeeper. Strong recordkeeping relationships and a lack of competing products with sufficient history cemented the largest recordkeepers and earliest market entrants as the largest TDF providers. In general, these prepackaged or off-the-shelf funds primarily use proprietary and actively managed investment strategies as their building blocks. With these actively managed, off-the-shelf options, multiple layers of management fees and a reliance on proprietary underlying fund managers tend to create significant headwinds to fund performance. Passive, off-the-shelf TDFs have grown in prominence in recent years as a modest rebellion against this proprietary, actively managed TDF model. These TDFs use indexation strategies as the underlying funds and create a lower-governance, lower-cost option for plan sponsors. While we see TDFs as a significant step forward in the evolution of DC plan design, they do bring increased governance complexity of which many plan sponsors may not even be aware. Not surprisingly, as TDFs have become the most prevalent default investment option, assets invested in TDFs have grown significantly. Morningstar s 2014 Target-Date Series Research Paper reports that mutual fund TDF assets increased from $115 billion in 2006 to more than $650 billion by the end of March 2014. According to data available from the Employee Benefits Research Institute, TDF assets within 401(k) plans tripled between 2006 and 2012, rising from 5% to 15% of aggregate 401(k) plan assets. At the same time, the number of participants holding TDFs more than doubled, increasing from 19% to 41%. In How America Saves 2014, Vanguard reports similar trends within its client base, with 55% of all participants using TDFs at year-end 2013, up from 10% in 2006. DOL Guidance for Fiduciaries In February 2013, the DOL published Target-Date Retirement Funds Tips for ERISA Plan Fiduciaries to give general guidance on selecting and monitoring Target-Date Retirement Funds Tips for ERISA Plan Fiduciaries Establish a process for comparing and selecting TDFs. Establish a process for the periodic review of selected TDFs. Understand the fund s investments. Review the fund s fees and investment expenses. Inquire about whether a custom or nonproprietary TDF would be a better fit for your plan. Develop effective employee communications. Take advantage of sources of information to evaluate the TDF and recommendations you received regarding the TDF selection. Document the process. (Fiduciaries should document the selection-and-review process.) Source: U.S. DOL Are You In the Wrong Target-Date Fund? 2

Over time, the TDF landscape has evolved to include more sophisticated product offerings and expanded implementation options, and the DOL has responded with their recent guidance. This provides plan sponsors with an opportunity to revisit their exposure relative to plan objectives and participant needs. When plan sponsors select a TDF, it is important to give full consideration to customized solutions as well as off-the-shelf fund options. These funds are designed by the investment manager within the constraints of their investment platform to meet the needs of a generic model participant, so they must be evaluated carefully to verify they fit the plan and its participants. A custom TDF offers a more tailored solution, as it is designed to meet the unique needs of plan participants according to objectives specified by the plan sponsor. However, it is important to recognize that a custom approach requires more governance. Special consideration should be given to the governance capacity of the committee or the willingness to separate the responsibilities of asset allocation, underlying fund management and implementation. Figure 2 illustrates the major decision points along the way. The Choice: Off-the-Shelf or Custom TDFs We believe a custom approach provides the greatest opportunity for plan sponsors to provide the TDF solution best suited to participants needs while managing the risks and outcomes specific to their plan needs. For organizations unable to pursue custom TDFs due to governance constraints (either insufficient time and expertise, or a lack of interest in unbundling responsibilities), we recommend considering passive, off-the-shelf TDFs. If custom TDFs are an option, the plan sponsor should carefully consider the complexities associated with them. The administrative burden of developing and implementing a custom solution poses added governance responsibilities. The implementation process is more complex than that of an off-the-shelf TDF, and the relative costs may be higher for plans that do not have sufficient scale to leverage institutional vehicles in order to save on fees. Figure 3 provides a comparison of off-the-shelf and custom TDF solutions. Figure 2. Key decision points A plan sponsor s off-the-shelf versus custom fund decision should be based first on governance capacity and next on qualitative and quantitative considerations. The dotted arrow pointing from off-the-shelf active to custom reflects Towers Watson s view that if active investment management is pursued, it is best done through a custom TDF solution. Custom Glide-path determination Portfolio construction/ active risk level Governance Figure 3. Off-the-shelf TDFs vs. custom TDFs Governance requirements Participant profile Fund evolution Off the shelf Simpler fiduciary oversight as single manager determines glide path and (typically) invests assets Designed for average investor profile, typically both retail and institutional Future structural changes can occur and are outside a plan sponsor s control Active Off the shelf Manager/ Glide-path selection Custom Passive Maximizes fiduciary oversight with fiduciary responsibility to design and monitor glide path along with underlying funds and operational protocols Customized based on specific demographics of participant base and the richness of benefits (e.g., salary, saving habits and retirement benefits available) Ability to control structural changes and overall design Implementation Simple implementation Consideration needed for implementation and ongoing monitoring as well as custom fact sheets and communication; compliance efforts and costs may increase Underlying funds Costs Underlying funds may not be highconviction managers or best ideas; monitoring necessary for underlying funds that may not be in core lineup More cost effective if passive underlying investments are utilized Access to select high-conviction managers and ability to leverage governance already in place if utilizing funds already in core lineup Strengthens institutional buying power of underlying core funds Are You In the Wrong Target-Date Fund? 3

In our experience, a custom approach is the preferred choice when any of the following are important to meeting plan sponsor objectives: Fiduciary risks. Custom funds maximize fiduciary oversight. The plan sponsor individually oversees the glide-path design, asset mix and underlying manager selection decisions. Having full control allows the plan sponsor access to preferred investment managers and can leverage existing relationships to streamline oversight and increase buying power to potentially reduce investment management fees. Custom investment beliefs. The plan sponsor can apply its own investment beliefs framework in the design of a custom TDF series, such as a preferred combination of passive and active management. If a sponsor develops proprietary capital market expectations, these can be incorporated in the TDF design decisions. An expanded set of investment choices such as real estate, hedge fund and risk parity strategies may also be available to improve the risk/reward profile of the TDFs. Importantly, the plan sponsor can decide how to define risk and focus the design of the TDF series to maximize outcomes relative to that risk metric (e.g., income replacement ratio, retirement income sustainability and volatility). Unique participant demographics or behaviors. The typical off-the-shelf TDF glide path assumes retirement at age 65 and incorporates many additional generic assumptions based on the broader population. If plan participants behave differently from the average DC plan participant (e.g., retiring before or after age 65, making aboveor below-average contributions, or earning more or less than the median income), a custom glide path can provide de-risking characteristics better aligned with participants needs. Comprehensive retirement benefits. For plan sponsors providing a defined benefit pension (or other benefits) in addition to the DC plan, a custom glide-path design allows for tailoring based on this supplemental information. Often, this can enable a more aggressive glide path and higher expected benefits, as participants should be able to tolerate more glide-path risk when they consider that risk in a broader portfolio context. It is important for any analysis to take into account the specific, unique characteristics and behaviors of the plan participants. One method is for plan sponsors to subdivide the plan population into cohorts, such as early- and late-career groups, and then evaluate the potential range of outcomes for each group using such measures as income replacement ratios and retirement success rates. The sidebar below outlines our basic consulting and investment belief framework. Towers Watson s TDF Beliefs Consulting beliefs Investment beliefs It is important for any analysis to take into account the specific, unique characteristics and behaviors of the plan participants. The glide path, asset allocation and implementation should be consistent with the investment beliefs, level of plan governance, participant demographics and behavior, and other retirement benefits available to participants. Glide-path design should include both the accumulation phase leading up to retirement as well as the postretirement phase. Risk should be defined in terms of achieving retirement readiness goals with a focus on multiple risk measures such as income replacement ratios and income sustainability under various drawdown scenarios. Plan sponsors wanting a low-governance or low-cost solution should consider off-the-shelf, primarily passive TDFs. For plan sponsors wanting to incorporate active management into the funds, a custom implementation should be the first consideration. TDFs should be broadly diversified across major global asset classes with minimal bias (style, cap, geography, etc.) and be based on rigorous analysis using reasonable assumptions and methods that are fully explained. TDF managers should seek to maximize investment efficiency on a net-of-fees basis and continually look to improve investment efficiency by considering modifications and new investment strategies. Glide-path design should reflect the declining value of human capital during the accumulation phase and a long time horizon in the postretirement phase. Are You In the Wrong Target-Date Fund? 4

Conclusion TDFs have become the dominant QDIA in DC plans. Plan sponsors using or considering TDFs as investment options must determine an implementation that will support the DC plan goals and lead to the desired outcomes for participants. The DOL s tips, which provide plan fiduciaries with guidance on selecting and monitoring TDFs, are consistent with the advice we have been giving to clients since the PPA was enacted. With TDF assets growing, the TDF landscape evolving and DC plans becoming the primary source of retirement income, we continue to emphasize that plan sponsors should evaluate TDFs relative to the unique objectives and characteristics of each plan. The plan sponsor has to determine whether a custom or off-the-shelf TDF option is appropriate. An important consideration is the governance capacity available to oversee the selection, implementation and monitoring of the TDF solution. Where governance capacity is limited, and for plan sponsors that do not wish to delegate through an outsourced solution, a custom implementation may not be feasible, and an off-the-shelf solution can be appropriate. For those who pursue an off-the-shelf solution, we recommend consideration of a low-cost, passively managed approach. Further Information For further information on how Towers Watson can help you, please contact: Lorie Latham +1 312 525 2436 lorie.latham@ David O Meara +1 212 309 3829 david.omeara@ Please note: This document was prepared for general information purposes only and should not be considered a substitute for specific professional advice. In particular, its contents are not intended by Towers Watson to be construed as the provision of investment, legal, accounting, tax or other professional advice or recommendations of any kind, or to form the basis of any decision to do or to refrain from doing anything. As such, this document should not be relied upon for investment or other financial decisions, and no such decisions should be made on the basis of its contents without seeking specific advice. This document is based on information available to Towers Watson at the date of issue and takes no account of subsequent developments after that date. In addition, past performance is not indicative of future results. In producing this document, Towers Watson has relied upon the accuracy and completeness of certain data and information obtained from third parties. This document may not be reproduced or distributed to any other party, whether in whole or in part, without Towers Watson s prior written permission, except as may be required by law. In the absence of its express written permission to the contrary, Towers Watson and its affiliates, and their respective directors, officers and employees, accept no responsibility and will not be liable for any consequences howsoever arising from any use of or reliance on the contents of this document, including any opinions expressed herein. About Towers Watson Towers Watson is a leading global professional services company that helps organizations improve performance through effective people, risk and financial management. With more than 14,000 associates around the world, we offer consulting, technology and solutions in the areas of benefits, talent management, rewards, and risk and capital management. Copyright 2014 Towers Watson. All rights reserved. TW-NA-2014-39498 /company/towerswatson @towerswatson /towerswatson