Are Custom Target Date Funds Right for Your Plan? Customization to Better Meet Participant Needs February 2012 Risk. Reinsurance. Human Resources.
Are Custom Target Date Funds right for your plan? As target date funds (TDFs) continue to take an increasingly important role in providing improved retirement security within defined contribution plans, more employers are choosing to improve this simplifying innovation through customization. This trend overlays the rapid growth in usage of target date funds. According to Aon Hewitt s survey, Trends & Experience in Defined Contribution Plans 1, only 33% of plans offered target date funds in 2005, and now they are offered by the vast majority of plans. The proportion of plan assets in target date funds has increased markedly as a result, with the TDF assets in some plans exceeding 50% of total assets. This momentum is expected to continue as the proportion of plans using TDFs as their qualified default investment alternative (QDIA) increases. Given the growth in plans deploying auto-enrollment and auto-escalation, the flow of assets making its way into TDF products is becoming a tsunami. These trends, coupled with unprecedented participant acceptance of this simplifying innovation in plan investment design, are generating widespread interest among plan sponsors in designing and deploying customized target date funds to better meet participant needs. The Problems with Pre-Packaged Vendor Products This is the first installment in a series of planned white papers Aon Hewitt Investment Consulting, Inc. (AHIC) is writing on next-generation solutions for defined contribution plans. As the role of DC plans in providing retirement security grows, AHIC believes the efforts of plan sponsors to improve how well their plans address participant retirement needs must grow as well. Look for subsequent editions in this series to focus on topics such as: Re-enrollment Incorporating retirement income solutions Structuring core investment lineups Transitioning monitoring and governance processes to better focus on participant outcomes Currently, a large percentage of plan sponsors use TDFs that are pre-packaged vendor products, commonly offered by an investment management firm that may also serve as the plan recordkeeper in bundled situations. These products typically use the vendor s proprietary funds as their component investment options. There is often little overlap between the funds underlying the target date fund and those in the plan s core lineup. The core menu monitoring and maintenance efforts of the plan fiduciaries have little if any impact on the component funds of the vendor TDFs, which are uniform and set at the product rather than plan level. Plan sponsors in these situations have minimal control over the quality or fee levels of the component funds, essentially facing an all-or-nothing approach in the selection and continued use of these tools. The sole means of control over TDF quality and cost is at the product level, where plan economics and vendor platform structure often dictate the availability and extent of product choice. This product-level decision extends to the most basic, and ultimately the most influential aspect of TDF design the glide path which defines the pace of transition from more to less risk as participant portfolios age. As plan sponsors attempt to incorporate considerations of plan demographics, benefit structure, or the presence 1 According to Aon Hewitt s 2011 survey Trends & Experience in Defined Contribution Plans, between 2005 and 2011, the proportion of plans using auto-enrollment increased from 19% to 56% and the percentage using auto-escalation increased from 9% to 51%. Are Custom Target Date Funds Right for Your Plan? 2
or absence of other plans into the TDF decision, an increasing number realize the various proprietary products available through the plan vendor are the bluntest of instruments. Under these circumstances, plan sponsors trying to select the best overall combination of underlying funds, fees, and glide path must inevitably compromise in one or more of these important design aspects. For many plan sponsors, the necessary compromises inherent in vendor TDFs are becoming less and less palatable, particularly as their use as the plan s QDIA has grown. As a result, many plan sponsors are considering customizing their target date funds to better meet their plan-specific standards and objectives as well as their participants retirement savings needs. What are Custom Target Date Funds (Custom TDFs) and how do they work? Custom TDFs are fully open-architecture target date funds in which plan sponsors select the asset classes to include, the funds to use, and the glide path that governs how those asset classes and funds will be allocated over time. Plan sponsors are able to monitor and adjust these custom TDF elements just as they do for the other aspects of their defined contribution plan investment structures, and the plan participants benefit from having TDFs that are more responsive to their needs. While implementation methods may vary based upon the plan recordkeeping structure, the essentials remain the same. The plan sponsor defines the component funds and their respective allocation proportions over time through the glide path, and the plan recordkeeper makes sure that money is directed to the right investment managers, in the correct proportions, for each custom TDF portfolio. Custom TDFs can be seen as offering the following potential advantages over proprietary, or off-the shelf, TDFs: Better managers, chosen from the high-quality core menu already in place Better fees, given the control over components and the economies of scale Better glide path, designed for the specific needs of the plan participants Better Managers. Because the custom TDF is drawn primarily from the existing plan core menu, the plan sponsor is able to select each fund individually, and therefore each is more likely to be, and ultimately to remain, best in class. As the plan sponsor monitors the core menu funds and replaces the managers whose quality has eroded, these changes are simultaneously replicated in the custom TDF portfolio that draws on this core menu. This is because the plan sponsor typically assigns funds from its core lineup to the corresponding asset class roles in the custom TDF 2. In this way, there is significant overlap between the managers in the core lineup and in the plan s custom TDFs, allowing close alignment of the plan investment governance process. Better Fees. Plan sponsors have greater control over custom TDF total fees than they do for proprietary or off-the-shelf target date fund products. This is driven by two dynamics: (1) investment managers tend to offer sliding fee schedules that favor larger allocations and flows, which tends to be the case when a plan uses the same funds in the core lineup and in the custom TDFs; and (2) plan sponsors gain greater 2 There may be additional funds in the custom TDF when asset classes are called for through the glide path analysis, but which are not considered suitable as a standalone core menu options. A common example of this is commodities. Are Custom Target Date Funds Right for Your Plan? 3
negotiating leverage by placing more assets with fewer managers. We believe most TDFs under a customized approach will deliver a lower aggregate cost than the off-the-shelf predecessor. Better Glide Path. While most participant groups exhibit unique characteristics that will influence the design of an optimal glide path, vendor proprietary target date funds have glide paths based on some typical or uniform participant population defined by a general set of assumptions. Further, most vendor glide paths are designed around asset accumulation, with little if any formal consideration given to participant retirement spending needs. Designing the glide path to incorporate the interaction between plan design, contribution patterns, investment, inflation, payout patterns, longevity, and other complementary retirement programs can markedly improve likely participant outcomes. Are Custom Target Date Funds Right for Your Plan? 4
Customization as a Potential Path to Improvement While custom TDFs may not be right for every plan sponsor, the proportion of plans using them has grown substantially over the past decade, and at an accelerating rate. Based upon Aon Hewitt s 2011 survey Trends & Experience in Defined Contribution Plans, plans using custom TDFs have grown from practically nil in the year 2000 to over 10% currently. In addition, judging from the questions asked about this approach AHIC has seen in recent Requests for Proposals, the interest is becoming widespread. The table below summarizes some of the key characteristics that indicate whether a plan sponsor would likely benefit from a custom TDF approach. Plan size Trait Unique sponsor situations Unique participant situations Strong plan management Strong core lineup Fee levels Defined plan purpose Characteristics that Suggest Greater Advantages for Using Custom Target Date Funds The additional complexity of custom TDFs generally favors their use among larger plans, given their greater capacity for administrative flexibility and their larger asset base, which tend to magnify the benefit from improvements to the funds, fees, and glide path. Plan sponsors with unique retirement benefit structures, like defined benefit plans, can often benefit from customization of the glide path to account for these factors. For example, a population with defined benefit accruals might be more inclined to take relatively higher risk in its defined contribution plan allocation design if the defined benefit plan elements are seen to cover the lower-risk portion of the participant portfolios. Populations with contribution or payout patterns that deviate from the average (potentially driven by different retirement patterns or mortality experience) can benefit from a customized target date fund approach. These patterns tend to be very different based on geography, industry, and job types. The plan sponsor must have a governance structure that is strong enough to successfully implement the additional responsibilities of a custom target date fund. Plans with strong core investment lineups can benefit more from custom target date funds by putting their core lineups into the target date funds. The amount of fee savings associated with custom TDFs will depend on the fee levels of the plan sponsor s core lineup and target date fund, as well as the potential fee reductions available for increased assets. Custom TDFs provide the flexibility of designing a glide path around retirement spending needs. Most vendor glide paths are designed and promoted in terms of their likelihood of providing improved savings accumulations. While there is considerable overlap between retirement spending needs and savings accumulation, they are neither identical concepts nor measured with the same metrics. Plan sponsors with strong views on the nature of the priority participant needs to be served by their plans are more likely to want to develop glide paths that most optimally meet those needs. Are Custom Target Date Funds Right for Your Plan? 5
Constructing and Comparing Different Glide Paths Aon Hewitt Investment Consulting, Inc. believes a key function of effective defined contribution plans is to help meet the retirement spending needs of participants. In our view, this means a number of characteristics should be considered in determining the relative level and types of investment risk taken, at any given time, when designing an optimal retirement savings platform. These characteristics generally include: Plan design, availability, and access Contribution patterns Pay increases Inflation Retirement patterns Payout patterns Anticipated longevity Other existing retirement programs AHIC uses all these characteristics in developing optimized glide paths for custom TDFs. We incorporate these factors and compare glide path performance in a risk-reward framework. For this, we develop composite participants that incorporate the characteristics listed above for actual plan participants. We model the performance of the glide paths drawn from our proprietary inventory for these sample participants, and then determine the best performers. For example, poor investment returns are not as much of a problem for participants who die young and conversely, mediocre (but not terrible) returns can be a huge problem for participants who live to be 105 years old. Even though longevity risk is generally uncorrelated with investment and inflation risks, there are interactions between them that make it important to look at glide paths through a lens that incorporates them all. As another example, a participant population with a defined benefit plan may have a different risk tolerance in its target date fund than a population without a defined benefit plan. Some people might be inclined to view the projected defined benefit payout as covering the lower-risk portfolio component role, allowing more risk to be incorporated into the target date fund platform. One of the key differentiators in this approach is the set of metrics we use to compare glide paths. Most proprietary or off-the-shelf TDF platforms, and even some custom TDF approaches, emphasize accumulated balances at retirement age. In our effort to define a more reliable measure of success, we refine the measure of the optimal balance at the target date through a stochastic modeling process that encompasses the entire expected life of the portfolio, including the spending phase. In the process, we put greater emphasis on metrics such as: Exhaustion age, or the age at which account balances reach zero. Accumulated balance as a multiple of pay (a measure of the size of the balance relative to the salary of a participant). Probability of exhaustion before death. Expected magnitude of shortfall (if balance is exhausted before death). We believe these metrics are better at evaluating how well a given glide path meets priority participant needs. We quantify the relative glide path quality by plotting them in a matrix that incorporates both the expected outcome (e.g., 50th percentile) and the degree of downside risk (e.g., 95th percentile). Are Custom Target Date Funds Right for Your Plan? 6
Exhibit 1 below shows an example of a comparison of glide paths based on accumulated balances as a multiple of salary. This exhibit is somewhat similar to the familiar efficient frontier chart, showing risk on one axis and expected return on the other. Moving up on the chart is preferable since it indicates better expected accumulation outcomes, and moving to the left is preferable since it indicates a lessening of downside risk. In this exhibit, the points labeled Vendors A through K represent the off-the-shelf platforms for some of the largest TDF providers, and the points labeled Optimized High Return and Optimized Low Risk represent the customized glide paths optimized based on two different risk tolerances. Exhibit 1: Comparison of Glide Paths Based on Accumulated Balances as a Multiple of Salary Are Custom Target Date Funds Right for Your Plan? 7
Exhibit 2: Comparison of Glide Paths Based on Exhaustion Age Based on these types of comparisons, we have found that vendor glide paths tend to fall short relative to custom-built glide paths when viewed using metrics that focus on retirement spending needs. This is to be expected considering the priority role asset accumulation is given in the design of vendor glide paths, typically at the expense of focus on the finer elements of retirement spending needs. Further, we expect the likelihood of having a one-size-fits-all vendor glide path being the optimal fit for a specific plan situation is remote at best. We believe plan sponsors strong interest in providing the TDFs likely to provide the best outcomes for their participants unique characteristics precludes trusting it to such a random chance. We therefore believe custom TDFs provide a better solution. Are Custom Target Date Funds Right for Your Plan? 8
Fiduciary Considerations Although AHIC is not a law firm, a paper on custom TDFs would be incomplete without a discussion of legal and fiduciary risks. In short, we have heard mixed opinions from ERISA attorneys. On one hand, a number of attorneys believe implementing a custom target date fund may also reduce legal and fiduciary risks. This view is informed by the three advantages of custom TDFs discussed earlier: the potential to have better funds, at better fee levels, incorporated into a better, more specifically responsive glide path. Aligning the funds in the target date fund with those in the core lineup, which the plan sponsor regularly monitors and maintains, can help protect the plan sponsor from the inherent risks and conflicts of depending upon vendor stewardship of vendor-managed funds. Reducing fees without sacrificing the quality of the fund lineup is a clear indication of effective execution of fiduciary responsibilities. Additionally, having the fiduciary actively research and consider the full range of potential glide paths is a much more robust governance process than simply choosing from a small set of vendor glide paths. On the other hand, some believe implementing a custom target date fund increases legal and fiduciary risks, as it requires the plan sponsor to make decisions that would not be required (at least not explicitly) with an off-the-shelf target date fund. Both perspectives on legal and fiduciary risk have validity in our view. It is important to note that capturing the potential fiduciary benefits requires that a plan sponsor have a strong and effective governance process. A plan sponsor that is lacking in its plan stewardship capacity should address this gap prior to initiating a custom TDF design project. AHIC recommends that plan sponsors discuss all potential fiduciary concerns with their legal counsel. We also believe evaluating the merits of customization is a fiduciary step in the right direction. Are Custom Target Date Funds Right for Your Plan? 9
Conclusion As target date funds are increasing in importance, plan sponsors are continuing to focus on improving them. In our view, custom target date funds are important tools that many plan sponsors should continue to evaluate as they strive to provide better retirement outcomes for their participants. Are Custom Target Date Funds Right for Your Plan? 10
Contact Information Scott Fisher Partner Aon Hewitt Investment Consulting, Inc. +1.206.467.4610 scott.fisher@aon.com Diane Vallerie Improta Partner Aon Hewitt Investment Consulting, Inc. +1.203.523.8152 diane.improta@aon.com John Miller, CFA, FSA, EA Associate Partner Aon Hewitt Investment Consulting, Inc. +1.949.290.5740 john.miller@aon.com Kevin Vandolder, CFA Partner Aon Hewitt Investment Consulting, Inc. +1.203.523.8144 kevin.vandolder@aon.com Are Custom Target Date Funds Right for Your Plan? 11
About Aon Hewitt Investment Consulting, Inc. Aon Hewitt Investment Consulting, Inc., an Aon plc company (NYSE:AON), is an SEC-registered investment adviser. We provide independent, innovative solutions to address the complex challenges of over 480 clients in North America with total client assets of approximately $1.7 trillion as of June 30, 2014. More than 270 investment consulting professionals in the U.S. advise institutional investors such as corporations, public organizations, union associations, health systems, endowments, and foundations with investments ranging from $3 million to $310 billion. About Aon Hewitt Aon Hewitt empowers organizations and individuals to secure a better future through innovative talent, retirement and health solutions. We advise, design and execute a wide range of solutions that enable clients to cultivate talent to drive organizational and personal performance and growth, navigate retirement risk while providing new levels of financial security, and redefine health solutions for greater choice, affordability and wellness. Aon Hewitt is the global leader in human resource solutions, with over 30,000 professionals in 90 countries serving more than 20,000 clients worldwide. For more information, please visit aonhewitt.com. Aon plc 2012. All rights reserved. Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc. This document is intended for general information purposes only and should not be construed as advice or opinions on any specific facts or circumstances. The comments in this summary are based upon Aon Hewitt Investment Consulting s preliminary analysis of publicly available information. The content of this document is made available on an as is basis, without warranty of any kind. Aon Hewitt Investment Consulting disclaims any legal liability to any person or organization for loss or damage caused by or resulting from any reliance placed on that content. Aon Hewitt Investment Consulting reserves all rights to the content of this document. Are Custom Target Date Funds Right for Your Plan? 12