Fiduciary Considerations with Target Date Funds Fees, Funds, and Glide Path November 2012 Hewitt EnnisKnupp, An Aon Company Copyright Aon plc 2012
Fiduciary Considerations with Target Date Funds Over the past several years, Target Date Funds (TDFs) have taken on an increasingly important role in Defined Contribution (DC) plans. They are included in far more plans now, than they were several years ago; for example, Aon Hewitt s survey Trends & Experience in Defined Contribution Plans 1 found that only 33% of plans offered TDFs in 2005, and now that figure has increased to 85% the vast majority of plans. 1 The growth in assets in TDFs is magnified because of their increasing use as the Qualified Default Investment Alternative (QDIA), coupled with more plans deploying auto-enrollment and auto-escalation. 1 In short, the flow of assets making its way into TDF products is monumental. They represent about $341 billion of retirement assets. 2 We view these trends favorably. TDFs serve a crucial purpose by helping participants form the most efficient portfolio relative to their time horizon. When compared to the typical participant s retirement portfolio, TDFs generally improve diversification, mitigate risk through rebalancing, and improve the likelihood of favorable retirement outcomes. At the same time, the increased use of TDFs naturally increases the assets invested in them. While the fiduciary standards exist regardless of the amount of assets, prudence may suggest that the amount of effort devoted to an area can vary based on the amount of assets affected. All investment decisions should be taken seriously, and those affecting large amounts of assets demand more attention. TDFs do not necessarily present greater fiduciary risks than other investments, since by their nature they are diversified and apply risk control measures without active participant intervention. As TDFs bundle a number of investment aspects and decisions together, analyzing them is more complex. While plan sponsors often find it easiest to select a pre-packaged TDF fund series from their current record-keeper, the fiduciaries retain the responsibility for evaluating the vendor s ability to provide an appropriate solution. Furthermore, the outsourced nature of these may provide fiduciaries a false sense of comfort because the day-to-day responsibilities appear to no longer lie with them. This white paper is intended to illuminate considerations to help fiduciaries keep their responsibilities top-of-mind. 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%. 2 Morningstar Target Date Series Research Paper: 2011 Industry Survey 1
When evaluating TDFs, the three major characteristics of TDFs that plan sponsors should focus on are: Funds Glide path Fees Glide Path participant outcomes Funds Fees Each of these factors will contribute to the overall impact on plan participants, and each presents challenges for plan fiduciaries. Funds For their core investment lineups, plan sponsors have created due diligence processes that attempt to hire and retain managers they believe are best-in-class for their mandates. While most plan sponsors have a similar review process in place for their TDF series as a whole, they typically do not extend that process to evaluate the individual managers comprising the TDFs. This is because a large percentage of plan sponsors use TDFs that are pre-packaged products, commonly offered by an investment management firm that may also serve as the plan record-keeper in bundled situations. These products typically use the vendor s proprietary funds as their component investment options deployed as all-or nothing mixes. Under these circumstances, the monitoring and maintenance efforts that plan fiduciaries perform for their core menu have little (if any) impact on the component managers of the pre-packaged TDFs, which are uniform and set by the vendor responsible for the TDF series. Therefore, plan sponsors in these situations have minimal control over the quality of the component funds, essentially facing an all-ornothing approach in the selection and continued use of these pre-packaged TDF platforms. This lack of control isn t necessarily a problem, as long as the plan fiduciaries ensure that there is a process in place to make sure the fund selection is done in a prudent way. 2
As an example of a potential issue, pre-packaged TDFs are often composed of strictly proprietary funds of a single firm, and it is very difficult for one manager to be best-in-class (or the most skillful) in every asset class. In addition, although many institutional investors use a carefully selected blend of active and passive management, pre-packaged TDFs are typically composed of either all active or all passive funds. Even if all of the funds are considered best-in-class at the time the TDF enters the plan lineup, this situation is unlikely to persist as time passes. Because of this, we ve seen situations where a plan sponsor terminates a fund in its core lineup only to find that it is present in the prepackaged fund lineup underlying the TDF. This is not necessarily problematic, if the overall quality of the funds is strong and the TDF provider has a good process in place for evaluating funds. However, the lack of plan sponsor control over component fund manager structure requires that the fiduciaries perform due diligence to gain comfort into the TDF manager s capabilities in these areas. While passive management in the TDF may help mitigate the obvious need for component control, this is not a panacea. The plan sponsor relies on the TDF product provider for the determination of which asset classes to include and in what proportion. Further, the selection of all passive mandates for all allocations at all points on the glide path should be examined from time to time, as the plan sponsor and/or TDF provider should consider the pros and cons of active management. Glide Path The glide path of a TDF describes how the asset allocation evolves as participants age. Every TDF has a glide path, and there are many different philosophies and methodologies for developing their trajectories. There is significant variation in risk level within the pre-packaged TDF products of the major providers. These off-the-shelf products are designed as one-size-fits-all platforms and are not customized to the specific circumstances and characteristics of particular plans. So when plan fiduciaries select a prepackaged TDF, they are responsible for ensuring that they select a provider whose particular approach for determining that glide path is appropriate for their population. We believe it may be appropriate to select the glide path (and TDF provider) either before, or in tandem with selecting the record-keeper. However, selecting a specific TDF provider simply because it is the record-keeper is, in our view, not best-practice. For example, a plan with a population whose demographic situation or preferences indicate the need for a lower risk allocation structure would be illadvised to use a TDF product designed for populations with average or above-average risk tolerance. Although the plan fiduciaries are giving the TDF provider responsibility for determining the glide path, the fiduciaries must ensure that the provider s TDF product is suitable for them, taking into account the specific circumstances of the plan participants. As there is improvement to the quality of available approaches and tools for determining the suitability of TDF glide paths for specific populations, this improvement becomes part of the expected basis for fiduciaries selection decisions. 3
Fees Managing plan fees is a key area of concern for DC plan fiduciaries. Plan fees directly erode the assets of the participants, and litigation involving plan fiduciaries and specifically focused on excessive fee levels has caused concern about many fiduciaries. As a result, many DC plan fiduciaries are focusing a growing proportion of their oversight effort on making sure their fee levels are reasonable. Plan sponsors with pre-packaged TDFs typically have a bundled fee for their TDFs, including prorated asset management fees for the various investment mandates underlying the portfolios. This is not inherently problematic, since it need not mean that fees are higher than appropriate. However, it does mean that fiduciaries will need to do additional work to compare TDFs with different underlying components and therefore differing fee structures. At this point, we believe it important to mention that DC plan fiduciaries need not deploy a plan with the lowest fees. Rather, their obligations are to act in the best interests of plan participants, which requires considering both the level of fees as well as the value provided for those fees. A TDF structure that features high-quality, actively-managed funds at reasonable fee levels may be more appropriate than a TDF with low-priced passively managed funds. However, either would be superior to a TDF with lowquality actively managed funds at high fee levels. This introduces a degree of complexity as well as subjectivity into the selection and monitoring process, and plan fiduciaries and participants are well served in being thoughtful in this area and documenting this process and diligence. Potential Solutions The solution to these challenges with TDFs is surprisingly simple: plan sponsors should rigorously consider the broad array of options for their TDFs, and select the one that is most appropriate for their situation. For pre-packaged TDF products developed by asset managers, this means considering the pros and cons for all three areas: funds, glide path, and fees. Plan fiduciaries should be thoroughly aware of the interactions between the major features of TDFs. The provider with the best funds underlying its TDF product may have a glide path that is not appropriate for every plan. Similarly, the provider with the best fees may not have best-in-class funds or a glide path that is appropriate for every specific population. And the provider with the most appropriate glide path for a specific plan may not have funds the plan s fiduciaries would use with confidence. The pre-packaged nature of these products presents fiduciary challenges by its very one-size-fits-all nature. An alternative, custom TDFs, has evolved over the last few years as plan sponsors have reviewed glide paths, fees and funds. Custom TDFs are fully open-architecture TDFs 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 evolve 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. The plan sponsor explicitly retains the decisions for more aspects of the TDF, and thus they are better able to control the risk exposure for their participants. The additional decisions imply that custom TDFs require more ongoing oversight. While these solutions were cutting edge just a few years ago, they are becoming increasingly common and more accessible to a growing array of plan sponsors. Even if there is not an 4
erosion of quality in the pre-packaged TDF a plan sponsor chose several years ago, the emergence of new options may warrant reviewing the current approach. One way for plan sponsors to decide whether to build their own custom TDF or select an off-the-shelf provider is to start by determining the characteristics of the ideal TDF for their plan population. What asset classes does it include and how does the glide path progress? What is the mix of active and passive management? What are reasonable fee levels? Once this is done, the next question is whether any of the vendor TDFs are sufficiently close to it, or if the best way to implement it is with a custom TDF. With this approach, a plan sponsor can be confident that it has considered all options and is selecting the one that best meets the needs of the participants. Conclusion Plan sponsors have always been responsible for their target date component funds, glide path, and fees. Many delegate much of this responsibility when they select a vendor s pre-packaged TDF. In our view, this may be all right, assuming the plan sponsor determined that the vendor s approach was appropriate for their participants, and monitors and evaluates the vendor and alternative approaches to ensure the continued appropriateness of the choice. Plan sponsors that chose their TDF offering by default when selecting their record-keeper, or who chose their TDF provider several years ago, will be well-served to review their TDF strategy regularly. New strategies for design, asset class selection, and monitoring are rapidly emerging, and best-practice dictates that plan sponsors review these options regularly. Further, as the litigation landscape evolves, there is little solace in the position that doing the same thing as many other plan sponsors offers comfort. Safety in numbers is by no means guaranteed. The trend is toward improved transparency on fees and investment practices. The best protection for plan sponsors is to have a comprehensive decision-making process in place for evaluating the best options for plan participants. Given the growing importance of TDFs and the evolution of TDF strategies, plan sponsors and participants should review their TDF approaches regularly. 5
Contact Information Scott Fisher Hewitt EnnisKnupp Seattle, WA +1.206.467.4610 scott.fisher@aonhewitt.com Eric Friedman Hewitt EnnisKnupp Chicago, IL +1.312.715.2973 eric.friedman@aonhewitt.com Diane Vallerie Improta Hewitt EnnisKnupp Norwalk, CT +1.203.523.8152 diane.improta@aonhewitt.com Kevin Vandolder Hewitt EnnisKnupp Norwalk, CT +1.203.523.8144 kevin.vandolder@aonhewitt.com 6
About Hewitt EnnisKnupp Hewitt EnnisKnupp, Inc., an Aon plc company (NYSE: AON), provides investment consulting services to over 450 clients in North America with total client assets of over $2 trillion. More than 270 investment consulting professionals in the U.S. advise institutional investors such as corporations, public organizations, union associations, health systems, endowment, and foundations with investments ranging from $3 million to $700 billion. For more information, please visit www.hewittennisknupp.com. About Aon Hewitt Aon Hewitt is the global leader in human resource solutions. The company partners with organizations to solve their most complex benefits, talent and related financial challenges, and improve business performance. Aon Hewitt designs, implements, communicates, and administers a wide range of human capital, retirement, investment management, health care, compensation, and talent management strategies. With more than 29,000 professionals in 90 countries, Aon Hewitt makes the world a better place to work for clients and their employees. For more information on Aon Hewitt, please visit www.aonhewitt.com. 7