Custom Target Date Strategies: Considerations for Plan Sponsors

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1 Custom Target Date Strategies: Considerations for Plan Sponsors May 2014 T. ROWE PRICE Investment Viewpoint EXECUTIVE SUMMARY Defined contribution plan sponsors that use target date portfolios can choose to implement a pre-assembled solution or to develop a custom product design. Customization may be of the glide path (including the underlying investment strategies), the underlying investment managers, or both. Sponsors should consider a number of key issues before deciding whether a custom solution is right for their plan. Customization can address a plan sponsor s desire to retain control of the investment strategy and the underlying investment managers. For some plans, the all-in costs of custom designs may be higher than with pre-assembled solutions. Empirical evidence suggests that plan sponsors should not necessarily expect performance improvements from customized solutions. Target date portfolios are popular investment options within defined contribution (DC) plans. Some plan sponsors use pre-assembled solutions offered by investment providers that incorporate either proprietary or sub-advised investment strategies, while others use custom target date portfolios. Interest in the latter was spurred in 2013 when the U.S. Department of Labor (DoL) issued a set of tips for ERISA plan fiduciaries on the topic of target date portfolios, which suggested that plan sponsors inquire about whether a custom or non-proprietary target date portfolios would be a better fit than a pre-assembled target date offering. 1 In doing so, the DoL noted that custom solutions may offer potential benefits, such as the ability to incorporate a plan s existing core lineup into the target date offerings and the ability to include component strategies that are managed by investment managers other than the target date provider itself, thus diversifying exposure to a single investment provider. However, the DoL also noted that customization may involve additional costs and administrative burdens on the sponsor, and thus may not be right for every plan. There are generally two ways that target date portfolios can be customized. One is by customizing the glide path and underlying asset classes per the plan s specific investment objectives and employee demographics. The other is by selecting a custom lineup of investment managers to manage the underlying strategies. (Figure 1, below). Figure 1: Target Date Choices for DC Plan Sponsors Least Customized Proprietary target date program with glide path design and underlying investment sleeves managed by a single target date provider, typically a large, diversified asset management company with experience across a wide range of asset classes and investment strategies. Source: T. Rowe Price Proprietary program in which the target date provider designs the glide path, but may include outside managers as subadvisors for the underlying portfolios. Plan sponsor uses a glide path provider s standard glide path, but utilizes core DC lineup or DB plan managers for the underlying portfolios. Most Customized Plan sponsor engages a vendor to design a custom glide path based on plan demographics. Managers may come from core DC or DB plans or be independently selected. 1 U.S. Department of Labor, Target Date Retirement Funds: Tips for ERISA Plan Fiduciaries, February,

2 THE DRIVERS OF SUCCESSFUL OUTCOMES FOR PLAN PARTICIPANTS We think of target date portfolios in terms of the outcomes they deliver for their investors. A number of factors drive participant outcomes within DC plans. In order of greatest impact, these factors can be broken down as follows: 1. Participant behavior How much do participants save, for how long, are loans taken, and what withdrawal strategies are used? 2. Glide path How much is invested in equity versus fixed income and cash? 3. Underlying investment strategies What asset classes are included in the equity and fixed income allocations, how diversified is the mix, and how sensitive is the portfolio to inflation? 4. Underlying investment managers What managers are selected to manage the individual strategies? The first factor has to do with participant saving and withdrawal behavior. The remaining factors have to do with the design and management of the target date strategy. CUSTOMIZING THE GLIDE PATH AND ITS UNDERLYING ASSET CLASSES/STRATEGIES Given the wide variety of standard glide path designs already available in the marketplace (Figure 2, right), it is unlikely that a DC plan would be so unique that a suitable glide path design could not be found. Still, if other reasons exist for the sponsor to consider implementing a custom solution, then it makes sense to evaluate whether the glide path should be customized, too. Customization may be achieved by designing a tailored glide path that reflects: The plan s demographic characteristics, such as employee retirement age, salary levels, contribution rates, matching rates, life expectancy, and the presence of other benefit programs such as defined benefit plans, and The plan s investment objectives, such as the balance the sponsor s wish to strike between the twin goals of lifetime income replacement and limiting the risk of capital loss near/during retirement. Sponsors may also desire to control the underlying asset classes and related investment strategies. Reasons for this include: A desire to incorporate additional asset classes, such as alternative investments, to improve diversification or adjust the risk/return profile of the investment strategy, A strong preference for a certain mix of active and passive management, and A strong preference for a certain mix of domestic and international strategies. Figure 2: A Diverse Range of Pre-assembled Glide Paths Are Available From Target Date Providers Level of Equity Exposure in Pre-assembled Glide Paths % Equity in Glide Path Source: Morningstar, June 2012 Another reason that a sponsor may prefer a custom solution is if the plan s demographics or investment objectives are expected to change materially in the future. In this case, a custom solution would allow for future glide path revisions within the target date portfolios, without having to convert to a different provider. Regardless, the demographics of any plan are likely to be quite heterogeneous. No glide path, however customized, can be considered optimal for every participant. Aggressive Lifetime Allocation Index Conservative Lifetime Allocation Index Target Date Providers Years Prior to (and After) Target Date 2 T. ROWE PRICE INVESTMENT VIEWPOINT

3 CUSTOMIZING THE UNDERLYING INVESTMENT STRATEGIES AND USE OF INVESTMENT MANAGERS Plan sponsors might have a number of reasons for wishing to manage and control the underlying strategies that make up the target date portfolio. Motives for customization might include: Desire for control of the underlying manager selection process. This may arise from: A belief that providers of suitable pre-assembled glide paths will not use due diligence criteria for investment performance, risk management, investment style discipline, or organization stability that meet the sponsor s standards. A desire to retain the flexibility to change the underlying investment managers: Open architecture makes it possible to remove specific managers without the need to switch to a different target date provider. A belief that the sponsor or their consultant can sufficiently identify so-called best-of-breed managers in each asset class, leading to better overall investment performance on a net-of-fee basis. Desire to leverage economies of scale: Sponsors may believe they can reduce overall investment management fees and other plan costs, such as those associated with monitoring and evaluating the investments, by combining investment management mandates across their DC and DB platforms. In addition to the strategies already used in the sponsor s DB plan, underlying strategies might also be sourced from the DC plan s existing core lineup or by working with an investment consultant. ITEMS FOR PLAN SPONSORS TO CONSIDER Depending on the plan sponsor s specific circumstances, either a custom strategy or a pre-assembled solution each might make sense for DC plans implementing target date offerings. However, there are a number of issues that we believe plan sponsors should consider before making their choice. Investment Performance It is often suggested that open architecture can improve the performance of target date strategies because it enables sponsors to select best-of-breed managers for the underlying investment components. However, there is little empirical evidence for the proposition that customized strategies have a structural performance advantage. When Morningstar surveyed the target date universe in a 2010, and again in 2012, it found no evidence of a performance advantage for openarchitecture. 2 (See Morningstar: No Clear Advantage for Custom Strategies, below.) Improved performance, then, may not be a justification for customization of the underlying investment managers or strategies. Plan Costs The prospect of lower plan costs also may be an incentive for target date customization. However, the expenses associated with developing a glide path, evaluating and selecting the underlying managers, and administering a series of custom, daily-valued investment portfolios may be higher than the all-in cost of pre-assembled target date strategies, especially for plans that do not have a sizable target date asset base. In addition, certain costs, such as the ongoing time demands on a sponsor s internal staff, may be difficult to quantify in advance. Sponsors may need to identify and vet a custodian and fund accountant who can value assets and strike daily net asset values, and establish guidelines that will streamline the trading tasks occasioned by daily participant activity. When evaluating the relative costs of custom and preassembled target date solutions, large plan sponsors also should be aware that some institutionally priced pre-assembled offerings offer cost efficiencies similar to or even larger than those provided by a customized approach. Using retail mutual fund fee structures as proxies for the costs of a pre-assembled target date solution, for example, can overlook the fact that less expensive institutionally-priced vehicles, such as collective investment trusts, may also be available. 2 Morningstar Target Date Research Papers

4 Operational Complexity Custom target date strategies may also face operational complexities that proprietary strategies with their fully-integrated trading, custody, and recordkeeping systems are inherently better equipped to handle. Functions such as managing cash flows, rebalancing, and risk management, for example, require continual, efficient coordination across portfolios and managers. Moreover, the need for efficient coordination is heightened during times of market stress such as experienced during the 2008 financial crisis. Sponsors should carefully consider the necessary resources required to manage custom solutions. Fiduciary Liability Plan sponsors should also carefully consider the extent to which electing to use either pre-assembled or custom target date portfolios affects their exposure to fiduciary liability. Custom strategies require a significant amount of expertise in a variety of areas. Detailed coordination is required, much of it on a daily basis. Strong stewardship and an effective governance process on the part of the plan sponsor are essential. Participant Communications Custom target date offerings may require specialized participant communication functions not typically found in most sponsor organizations. Since the 2008 financial crisis, both the DoL and the Securities and Exchange Commission have stressed the need to keep participants informed of developments in their target date portfolios. Customization can make communication more burdensome in the following ways: Arrangements will need to be made to have performance documents forwarded from the underlying target date investment managers. Benchmark information will have to be calculated and disclosed to participants. Third-party analysis (such as Morningstar fact sheets) also may need to be provided. The timeliness of regulatory disclosures may prove burdensome. Additional materials, training, systems programming, and oversight may need to be incorporated into the plan s phone, employee meeting and participant web support models. Proprietary target date managers typically provide these communication services as part of a bundled target date service. Morningstar: No Clear Advantage for Custom Strategies Part of the appeal of custom target date platforms is their open architecture, which some plan sponsors may believe will lead to better investment performance. But when Morningstar surveyed the target date universe in a 2010, and again in 2012, it found no evidence of a performance advantage for open-architecture. In both surveys, Morningstar divided target date products into three groups: open, closed, and mixed (while noting that the mixed strategies were largely indistinguishable from open ones, in that their managers typically had the ability to invest 100% of assets with external sub advisors). Analysts then looked at a range of performance measures, including risk-adjusted returns, return attribution, and the Morningstar ratings for each target-date series and strategy. A second analysis zeroed in on the ratings of the underlying strategies, eliminating the performance effect of glide paths and focusing only on underlying manager quality as defined by the Morningstar rating system. 1 The results of the 2012 survey are summarized in Figure 3, at right. As can be seen, the underlying strategies in the closed-architecture target date series actually had slightly higher average Morningstar ratings than either the open or the mixed series over the 3-year and 5-year periods ending December 31, Morningstar s report concluded that the evidence fails to support the contention that open-architecture target date funds are superior to closed-architecture offerings. If anything, closedarchitecture series appear to have a slightly better track record. Figure 3: Morningstar Ratings for Underlying Strategies in Target Date Products, By Architecture Periods Ending December 31, 2011 Number of Products in Category 3-Year Average 5-Year Average Closed Mixed Open Mixed & Open Source: Morningstar 4 T. ROWE PRICE INVESTMENT VIEWPOINT

5 High-Level Questions for Plan Sponsors to Consider Will a custom target date solution improve participant acceptance and use? Plan sponsors need to consider whether customization will create a glide path that better fits the needs of their participants. They should keep in mind that participation and deferral rates not glide path design are the most important determinants of plan outcomes. Will a custom solution result in lower costs to participants and sponsors? The all-in costs of developing a glide path, hiring managers, and administering a series of customized, dailyvalued products may be higher than the all-in costs of a pre-assembled strategy if a plan does not have a very sizable asset base and the resources to oversee investment and operations professionals. Is a custom design likely to lead to better investment outcomes? There is no evidence that customized strategies have an advantage over proprietary ones. If anything, the underlying portfolios in closed-architecture strategies appear to have a slightly better track record, according to recent Morningstar research (See Morningstar: No Clear Advantage for Custom Strategies, page 4). Are the benefits of customization worth the cost of the resources required? Designing and implementing a custom target date strategy can be a complex undertaking, and may impose significant burdens on sponsors administrative budgets and/or consulting costs. POTENTIAL ADVANTAGES OF PROPRIETARY TARGET DATE OFFERINGS Given the potential costs and administrative burdens involved in the design and implementation of custom target date offerings, DC plan sponsors contemplating such solutions should also examine whether a proprietary target date provider might serve the needs of plan participants in a more cost-effective way. Potential benefits of proprietary strategies include: Established track records and benchmarks. Proprietary target offerings have established track records and ratings by Morningstar and other investment research services, allowing sponsors to evaluate investment performance relatively easily. Benchmarking custom strategies is a more difficult exercise. Clear lines of communication among investment and operations professionals. As members of the same firm, portfolio managers are more likely to interact on a day-to-day basis, giving them a detailed understanding of each other s investment process and current thinking. An integrated team allows for operational efficiency in tasks such as cash flow management, portfolio rebalancing, and the addition of new asset classes to the glide path. Transparent portfolios. By their very nature, proprietary target date portfolios give every member of the management team access to all available information about the portfolios in the strategy, including current holdings, attribution analysis, and risk factor exposures. This level of information allows them to evaluate the impact of their investment decisions on absolute and relative performance down to the individual security level, if necessary and communicate that analysis to plan sponsors and their consultants. A coordinated approach to risk management. Proprietary target date offerings can set appropriate, coherent sector, industry, or position constraints, or other diversification guidelines, for their underlying portfolios, and ensure that they are consistently followed. This facilitates the creation of portfolios that have the potential to deliver solid risk-adjusted performance. Comprehensive participant communications. Proprietary target date providers typically are highly experienced at developing communications strategies for participants designed to generate better retirement outcomes. They may offer customized materials to explain the target date series, trained phone representatives, video webinars, and in-person employee meetings as a bundled package of participant communications services. 5

6 Increasingly flexible investment options. Target date providers have greatly expanded their investment offerings in recent years to include institutionally priced collective trusts, hybrid active and passive investment solutions, additional asset classes, and multiple glide paths. CONCLUSIONS Target date strategies have become popular investment solutions for encouraging and simplifying DC plan participation. They provide well-designed alternatives to do-it-yourself asset allocation, making them suitable plan default offerings. Encouraged by this evolution, many DC plan sponsors are now considering whether customizing their target date offerings with planspecific glide paths, independent manager selection, or both might yield additional benefits for participants. For plan sponsors with a strong desire for control and flexibility over the design and/or implementation of their target date offerings, custom strategies may be an attractive solution. On the other hand, cost and performance do not appear to be particularly strong reasons for seeking a custom solution. Costs including glide path design, manager selection, participant communications, and administration may actually be higher than they are for pre-assembled strategies. The rigors of continuous monitoring and evaluation may prove burdensome and difficult. Evidence that best-of-breed manager selection will lead to better performance is also lacking. In light of these issues, T. Rowe Price strongly recommends that plan sponsors carefully weigh the relative advantages of both custom and pre-assembled target date strategies in order to make an informed and cost-effective investment decision on behalf of their participants. 6 T. ROWE PRICE INVESTMENT VIEWPOINT

7 T. ROWE PRICE AT A GLANCE Established in 1937 by Thomas Rowe Price, Jr., T. Rowe Price is headquartered in Baltimore, MD, with offices located in the Americas, Asia, Australia, and Europe. The firm offers a full range of investment strategies across multiple asset classes, capitalizations, sectors, and styles. Investment vehicles include separately managed portfolios, mutual funds, commingled vehicles, and subadvised portfolios. It has over 5,000 associates worldwide, including 430 investment professionals. T. Rowe Price is a publicly traded firm (TROW) and is one of the few independent investment management firms included in the S&P 500 Index. The principal value of target-date funds is not guaranteed at any time, including at or after the target date, which is the approximate date when investors plan to retire. These funds typically invest in a broad range of underlying mutual funds that include stocks, bonds, and short-term investments and are subject to the risks of different areas of the market. In addition, the objectives of targetdate funds typically change over time to become more conservative. Call to request a prospectus, which includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing. 1 For funds with at least a 3-year history, a Morningstar Rating is based on a risk-adjusted return measure (including the effects of sales charges, loads, and redemption fees) with emphasis on downward variations and consistent performance. The top 10% of funds in each category receive 5 stars, the next 22.5% 4 stars, the next 35% 3 stars, the next 22.5% 2 stars, and the bottom 10% 1 star. Each share class is counted as a fraction of 1 fund within this scale and rated separately Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. T. Rowe Price Investment Services, Inc., distributor, T. Rowe Price mutual funds. Important Information This information is provided for informational and educational purposes only and is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. This Investment Dialogue provides opinions and commentary that do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision. Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy. Past performance cannot guarantee future results. All charts and tables are shown for illustrative purposes only. The views contained herein are as of April 2014 and may have changed since that time US /14 7