Target-Date Funds: Not as Simple as Set It and Forget It

Target-Date Funds: Not as Simple as Set It and Forget It This article includes checklists for issues defined contribution plan sponsors must address under new disclosure rules as part of their due diligence related to offering target-date funds as investment options. by Martha Spano reprint PU1 2 8 0 2 0 MAGAZINE pdf/312 Reproduced with permission from Benefits Magazine, Volume 49, No. 4, April 2012, pages 14-19, published by the International Foundation of Employee Benefit Plans (www.ifebp.org), Brookfield, Wis. All rights reserved. Statements or opinions expressed in this article are those of the author and do not necessarily represent the views or positions of the International Foundation, its officers, directors or staff. No further transmission or electronic distribution of this material is permitted. Subscriptions are available (www.ifebp.org/ subscriptions). 2 benefits magazine april 2012

Although target-date funds (TDFs) are extremely popular investment vehicles for defined contribution (DC) pension plans, there continue to be significant misperceptions and misuses of TDFs. As a result of heavy losses in these funds in 2008-2010, the Department of Labor (DOL) and the Security and Exchange Commission (SEC) have proposed more due diligence of TDFs by plan sponsors. This article addresses a number of issues regarding TDFs and provides a due diligence checklist to review a plan s TDFs. TDF s Original Vision A TDF, or lifecycle fund, is a single investment vehicle with holdings in a series of multi-asset-class funds, designed to manage retirement savings risks. TDFs provide automatic asset allocation and rebalancing. They assume a more aggressive allocation to equities in the early years, but roll down to a more conservative position each year as the fund approaches its target date, usually the participant s retirement date. This annual roll-down is called the glidepath as the participant nears his or her anticipated retirement. TDFs have become extremely popular in the last ten years, growing from an asset base of $12 billion in 2001 to over $246 billion in 2009. There are several reasons for their popularity: The TDF approach counters participants inertia in rebalancing their DC assets as they move through their career. This set-and-forget mentality divorces the investment decisions from the participant s emotional influences, especially the fact of buying high and selling low or following the hot dot. Participants need to identify only their anticipated retirement date. They no longer have to struggle to define their risk tolerances, a requirement of lifestyle funds that preceded TDFs. DOL in essence sanctioned TDFs as a viable investment vehicle by designating TDFs as one of the three qualified default investment alternatives (QDIAs). The market volatility of 2008-2010, however, caused significant losses in most TDFs ranging from a loss of 9% to 40%, with an average of about 25%. These losses were most painfully felt by participants in the 2010 funds who were within two years of retirement april 2012 benefits magazine 15

learn more >> Education Investments Institute April 23-25, White Sulphur Springs, West Virginia For more information, visit www.ifebp.org/investments. Choosing a Target-Date (Lifecycle) Fund Family For more information, visit www.ifebp.org/elearning. From the Bookstore 2012 Pension Answer Book by Stephen J. Krass. Aspen Publishers. 2012. For more details, visit www.ifebp.org/books.asp?8920. date. With the magnitude of losses in TDFs, the regulators increased their scrutiny of how TDFs were constructed. Joint hearings by DOL and SEC promulgated a series of bulletins and proposed disclosure regulations, imposing more due diligence on those fiduciaries that offer TDFs in their plans. Under the new disclosure rules, plan sponsors now must take a closer look at their TDFs as part of their due diligence, and address a series of issues regarding TDFs: The asset allocation The roll-down of the glidepaths How the allocation changes over time The fees associated with the funds How the funds are implemented active or passive management Additional disclosures about the possibility of losses in these funds. Glidepath Construction TDFs differ in the roll-down and the allocation to equities as well as in the types of asset classes that are involved. It is typical for TDFs to start out with a higher equity allocation and then roll down or decrease the equity allocation as the fund nears the target date for retirement. The idea is that as participants get closer to retirement they will want to have less volatility in their portfolio. In the last ten years, bonds have done well against stocks. But given the current level of interest rates today, a higher bond allocation cannot provide enough growth potential to keep pace with inflation. So there are several issues that need to be considered in the glidepath construction. First, each fund family series of TDFs rolls down differently. Although the underlying philosophy governing the funds is similar, there are significant differences in the portfolio allocation along the investment horizon as well as the end date. For example, most TDFs start at 90-100% in equity, but can range from 30% to 60% at the targeted retirement date, 40 years later. Several TDF glidepaths are illustrated in the figure. Generally, the reason for the wide disparity in end-date allocations is based on the difference in end-date philosophy the to or through approach. Several fund families believe that participants have differing behavior at retirement. Some participants will leave their money in the plan and will use systematic withdrawals during their retirement years. This underlying through retirement philosophy assumes that these participants can withstand some market volatility, and thus there is a higher allocation of equities at the retirement date as the actual time horizon is extended another 20 to 30 years. On the other hand, if participants pull their money out of the plan at retirement, then they will want a glidepath that is more conservative, and they cannot stand any further volatility as they near the retirement date. This is the to approach. This is further complicated by the fact that plan sponsors usually must select one approach, which may not be appropriate for all their participants. It behooves the plan sponsor to survey its retiree base to better understand the distribution behavior and thus better align participant goals to the most suitable philosophy of to or through. According to a recent Vanguard report, 28% of plan sponsors offer TDFs that employ the through philosophy, but as plan sponsors better understand the to versus through issue, this may increase. Other considerations that influence retirement behavior are the existence of a defined benefit (DB) plan that provides a minimum income floor, the actual retirement date for the participant population and the percentage of income that Social Security replaces. A second significant issue regarding the glidepath construction is that TDFs differ in the asset classes used to create the fund. There could be as few as three traditional asset classes involved in the TDF s portfolio construction, or as many as 50 asset subclasses. Many TDFs now include some inflation protection in the form of Treasury inflationprotected securities (TIPS) and real estate investment trusts (REITs), while others have alternative assets such as hedge funds and private equities. These nontraditional asset classes 16 benefits magazine april 2012

FIGURE Strategic Glidepath Total Equity Exposure 110% 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Total Equity % 2050 2045 2040 2035 2030 2025 2020 2015 Target Retirement Year 2010 2005 Black Rock Lifepath AllianceBernstein Fidelity Freedom JPMorgan Smart Retirement T. Rowe Price Retirement Vanguard Target Retirement Schwab Target Industry Average can add volatility to the portfolio, especially in the short term, but offer inflation protection and growth potential over the longer term horizon. The timing for adding nontraditional asset classes into the fund and when the glidepath actually employs diversifiers such as TIPS, commodities and hedge funds to reduce volatility presents another issue. This can have a big impact on performance. It s essential that plan sponsors understand the composition of the underlying asset classes to better communicate the risks involved in the TDFs provided to their participants. An additional factor plan sponsors should review is the number and type of underlying funds that make up the TDFs. Most importantly, plan sponsors should monitor proprietary funds (from a fund family) that are part of the TDFs, and determine whether there are additional fees for the underlying funds. There are two other glidepath construction features that plan sponsors should monitor. One is the way the asset classes are implemented whether the fund is using a passive or active management approach as this has a significant impact on both fees and performance. The other is the frequency with which the underlying asset classes and funds are rebalanced. Recent studies have indicated that about 20% of the funds rebalance monthly, while 14% do this quarterly. The remaining funds rebalance annually. This may also influence performance. Glidepath Checklist Due diligence on the glidepath should include these steps: Analyze the glidepath roll-down Employee demographics Participant behavior at retirement. Review the underlying portfolio construction Underlying funds/managers Asset classes used. Evaluate how the TDFs provider mitigates downside risks through diversification and addition of nontraditional asset classes. Ensure communications explain the glidepath properly. Assess whether TDFs are through retirement or to retirement and assess how well this aligns with the distribution behavior of the participants. Benchmarking Benchmarking TDFs is a contradictory exercise because, as mentioned above, different TDFs vary in their portfolio construction and their rolldown. Additionally, specific fund families may have an inherent equity bias either growth or value which affects the performance of the TDF. These factors make it even more difficult to benchmark the funds, and the market april 2012 benefits magazine 17

takeaways >> Regulators have increased scrutiny of how TDFs are constructed. Plan sponsors must usually select a single approach for a TDF s end-date philosophy either to retirement or through retirement which may not be appropriate for all participants. The retiree base should be surveyed. Plan sponsors should understand the composition of underlying asset classes in a TDF so that they can communicate the risks involved. A 1% increase in fees can reduce an account balance by more than 17% over 20 years. Although prepackaged TDFs may be simpler for a plan sponsor, the sponsor is still liable for due diligence on underlying funds and managers, rebalancing and creating the glidepath. has not kept pace with the evolution of TDFs. However, there are several peer universes that can be used including Lipper and Morningstar, and many consultants can create a custom TDF peer universe for review. But the most optimal benchmark is still one constructed from the passive index weights in the same proportion of the underlying assets as the TDFs. If a TDF is passively implemented, then there should be minimal tracking error to the index benchmark. If the TDF employs active management, then one would expect that the active management should outperform the indexes that make up the benchmark. It s important to note another current trend that creates a retirementadequacy benchmark based on each individual participant s replacement ratio goal. This approach involves a much more sophisticated and tailored mechanism for measuring and benchmarking the savings target, the contribution rate and the earnings of each individual s TDFs account. Although much more accurate for the individual participant, it is also more costly for the plan sponsor to implement and communicate, and has not yet gained popularity. Benchmark Checklist Action steps for benchmark due diligence are: Determine what index or composite index to use Vendor provides Consultant provides Custom index. Have the consultant create a universe periodically to compare the plan s TDF series to others. If the plan sponsor has selected an active TDFs series, periodically compare to an index version. Understand the inherent biases in the prepackaged funds. Understand the performance attribution from both the asset allocation and the underlying fund performance. Fees The majority of TDFs utilize the mutual fund structure, where expenses are expressed as an expense ratio. The expense ratio includes the management fee, the operating expenses, and the commissions and sales loads for the fund. The average expense ratios for TDFs range from a low of 19 basis points (for passive funds) to a high 182 basis points (for active funds), according to a 2009 Morningstar survey. This is a difference of over 160 basis points. More importantly, more than half of all TDFs have an expense ratio of over 100 basis points. Fees are based on the active versus passive approach, the allocation to equities as equity management is more expensive than fixed income management the use of nontraditional assets, which are again more expensive to manage, and the share class of the mutual fund retail versus institutional. Given the recent DOL focus on fees, plan sponsors need to monitor the fees for TDFs. According to the DOL illustrations in its TDFs bulletin, a 1% increase in fees can reduce an account balance by more than 17% for a 20-year period. Plan sponsors must understand the TDFs fund composition and the fees that are attributable to the asset classes, the underlying funds, any additional fees for rebalancing and the difference between the share classes of the same fund. Fees Checklist Action steps for fee due diligence are: Review and compare fees against a credible universe. Determine fees for management and if there is a separate fee for asset allocation and rebalancing. Review asset allocation fees for equity management are higher than for fixed income. Passive investing is less expensive than active management. Determine if there are additional fees flowing through from the underlying funds. Look at the share class of the 18 benefits magazine april 2012

funds should be using institutional versions or collective trusts. Prepackaged Versus Custom TDF A discussion of fees naturally leads to the comparison between the prepackaged mutual funds and a custom approach to TDFs. (In a custom TDF, the plan sponsor uses the current lineup of funds and managers to create its own custom TDFs and develops a glidepath that aligns specifically to the demographics of the employer s population.) The advantage of a prepackaged TDF is that a fund family TDF is a bundled service offering, and the plan sponsor doesn t need to select the underlying funds and managers, rebalance the fund allocation or create the glidepath. However, the plan sponsor is still liable for the due diligence on all these factors. In contrast, a custom TDF allows the plan sponsor to develop a glidepath more aligned to its employee population, and utilize the current funds and managers used in its DC and DB plans. This can entail less fiduciary oversight since the plan sponsor is already reviewing the current managers, and if assets are aggregated, this could result in lower fees. A custom TDF allows the plan sponsor to add alternative asset classes and annuity options. Adding an annuity option is the approach United Technologies employed in creating its own TDFs. The disadvantages of the custom approach are that a plan sponsor is now required to review the glidepath periodically, to evaluate the underlying asset assumptions used in the construction of the glidepath and to rebalance it periodically. A plan sponsor must assess whether it has the capacity and resources to implement a custom TDF because of the additional design, review and rebalancing functions. If it does, a more specific alignment with its participants career horizon may allow for a more secure retirement. Summary TDFs are more complicated than the majority of investment options offered in a 401(k) plan. That means there is more responsibility on the part of plan sponsors to know what they are providing to their participants. There are a number of steps plan sponsors can follow to ensure they are conducting good due diligence, as illustrated in the sidebar, as part of their fiduciary monitoring and oversight. Fiduciary Checklist for Evaluation of Prepackaged Target-Date Funds << bio 1. What is the equity starting point? What is the equity endpoint? 2. What are the roll-down intervals? 3. How many asset classes are involved in the glidepath construction? 4. When do various asset classes come into the glidepath? How are the asset classes implemented active/passive? 5. How many underlying funds make up the TDF? How many are proprietary funds? 6. What is the TDF s philosophy on to versus through? 7. How frequently is the allocation rebalancing done monthly? Quarterly? 8. What is the recommended benchmark? Is it a custom benchmark? 9. What is the appropriate peer universe? 10. What is the performance of the funds versus their peers? Can the plan sponsor review the performance of the underlying funds? 11. Is there an inherent style bias in the equities portion of the TDF? 12. What are the fees? How do they compare to their peers? 13. Is there a separate fee for rebalancing? Are there additional fees for flow through of underlying funds? 14. Is there a retirement income option attached to the TDF? What is it? An annuity feature? Or a GWB (guaranteed withdrawal benefit) feature? What is the fee for this component? 15. How are the TDFs being utilized? Martha Spano is a principal, investment practice leader and investment consultant for Buck Consultants in Los Angeles, California. She is responsible for all aspects of investment consulting, including governance, investments, manager structure and selection, and performance monitoring. Spano earned a B.S. degree in criminal justice from California State University, Long Beach, and master s degrees from California State University, Long Beach, and the Straus Institute of Law at Pepperdine University. She can be contacted at Martha.spano@buckconsultants.com. april 2012 benefits magazine 19