CALLAN INVESTMENTS INSTITUTE September 2015 Research Target Date Funds Finding the Right Vehicle for the Road to Retirement There seems to be no stopping target date fund (TDF) strategies, which are growing both in use within defined contribution (DC) plans and in products available. Each TDF manager differs in their underlying philosophy, which shapes construction and implementation. The wide variety of options represents both a benefit and a challenge. As plan sponsors examine and monitor TDF options they must be aware of the differences and how these differences can ultimately affect participant outcomes. This paper draws on Callan s comprehensive data on TDFs and DC plans, which is gathered and analyzed annually. We present key findings and highlight questions plan sponsors may want to consider when evaluating their TDF options. Nobody with a good car needs to worry about nothin, do you understand? Hazel Motes in John Huston s Wise Blood (1979) Just as people rely on cars to get them where they need to go, Americans increasingly depend on TDFs to help them achieve their retirement goals. For the first time since the inception of the Callan DC Index in 2006, TDFs (25%) recently beat out U.S. large cap equity (24%) as the largest portfolio allocation in DC plans. As part of Callan s annual DC Trends Survey, more than 140 DC plan sponsors were asked about their use of TDFs. Callan also annually collects qualitative and quantitative data from target date managers representing both mutual funds and collective trusts. This paper leverages this combined data to examine the current state of the TDF universe and the differentiating characteristics that help drive outcomes. Knowledge. Experience. Integrity.
Exhibit 1 Product Offerings and Utilization A Look Inside the Showroom: The TDF Universe Plan sponsors face a plethora of options there are more than 40 off-the-shelf, unique target date series (including both mutual funds and collective trusts) and they range widely in implementation approaches. While there are more active TDFs than passive (70% have some active management, see Exhibit 1), DC plans typically adopt passively managed TDFs. However, even those TDFs with completely passive implementation still must make active decisions regarding the strategic construction of the glide path the implementation may exclusively utilize index funds, but the asset allocation decision is active. 1 No target date suite is truly 100% passive. Life in the Fast Lane Since 2010, six providers have Active Passive Blended exited the target date space Products 41% 31% 29% but eight have entered it. Manager Plan Utilization 35% 4 24% exits are frequently due to difficulties in garnering assets., utilization figure from Callan s 2015 DC Trends Survey The TDF market historically has been dominated by those Across the universe of TDFs, providers utilizing their own underlying funds predominate (61%). The remaining managers (40%) offer some degree of open-architecture (non-proprietary) funds within the target date glide path, such as index funds or ETFs. 2 with recordkeeping arms that can significantly help with distribution. Existing target date providers also have the ability to add more glide path offerings Mutual funds continue to be the most common investment vehicle to their product lineup. for target date products (Exhibit 2). Mutual funds enable managers to address both the 401(k) market and the growing 403(b) market. Roughly one-third of managers make both mutual fund and collective trust versions of their TDFs available. Often the collective trust is targeted to the institutional market and the mutual fund at the retail market and advisor channel. Only 11% of managers exclusively offer collective trusts. These managers might focus primarily on the institutional market or view the lower cost of setting up a collective trust as the main reason to eschew the mutual fund world. Exhibit 2 Vehicle Availability Collective Investment Trusts 11.4% Both 31.8% Mutual Funds 56.8% Note: Throughout this paper, charts and data may not sum to 100% due to rounding. 1 Glide path refers to the gradual change in asset allocation as a participant ages. 2 Some may question whether the use of non-proprietary index managers truly constitutes an open-architecture solution. 2
Plan Sponsor Considerations: TDF Implementation Are you comfortable with your target date manager s overall implementation? Are you aware of what underlying asset classes are passively implemented? Does your manager offer your TDF in a lower-priced vehicle? If so, are there differences in the underlying implementation? Sticker Price: The Going Rate for TDFs The choice of underlying funds and vehicles largely drives fees. Looking at the lowest-cost share class and trust class in the collective trust and mutual fund universes, Callan s database shows the median fee is 60 basis points. The overall range, which has widened slightly compared to previous years, goes from 16 basis points at the cheapest end (10th percentile) of the spectrum to 82 basis points at the most expensive (90th percentile). From the manager s perspective, these fees include investment management and sometimes reflect an additional fee for the asset allocation work that goes into target date design. Increased competition, particularly among index TDF providers, has led to a downward trend in fees. Exhibit 3 1.0% Median Investment Management Fees for Target Date Funds Median Fee 0.5% Calendar Year 2010 2015 0.65% 0.59% 0.74% 0.6 0.77% 0.66% 0.79% 0.66% 0.81% 0.70% 0.0% 2010 Fund 2020 Fund 2030 Fund 2040 Fund 2050 Fund Vintage Plan sponsors concerns about potential fee litigation has exerted more downward pressure on fees. The median fees of near-term vintages, such as 2010 funds, shrunk by six basis points (from 0.65% to 0.59%), while longer-term vintages have experienced an even greater decrease in fees over the last five years (Exhibit 3). Interestingly, even as TDFs equity allocations have declined relative to 2010, their composition has shifted toward more expensive asset classes, such as emerging markets. Providers typically are able to reduce overall fees by offsetting more expensive sources of equity with increased allocations to passive U.S. large cap equity. This allows managers to stay within their fee budget and remain competitive while also incorporating more diversifying asset classes. Knowledge. Experience. Integrity. 3
Plan Sponsor Considerations: Fees How competitive are your provider s fees? Has the provider added value commensurate with their level of fees? Have you benchmarked fees to appropriate peer groups (e.g., active/passive and vehicle type)? Does your fee reflect only the underlying investments or is there an additional layer of fees for asset allocation/manager selection? Fuel Injectors: The Evolution of Equity Exposure The 2008 bear equity market was a catalyst for many changes to TDFs, primarily to risk management. Due in part to aggressive equity allocations, many of these supposedly staid funds experienced losses of 25% or more. Returns for managers of 2010 TDFs during the crisis ranged from -29.0% (90th percentile) to -14.5% (10th percentile) with a median of -22.7%. In general, TDF providers reduced equity exposure after 2008 (Exhibit 4). The red line representing the average equity rolldown of TDFs today is lower throughout the glide path than the green line (2010). Equity allocations were even lower in 2012. For example, the average equity allocations for 45-year-old participants Exhibit 4 Equity Exposure by Age 100% Calendar Year 2010 2015 80% Equity Exposure 60% 40% 20% 25 30 35 40 45 50 55 60 65 70 75 80 85 Age 4
(a 2035 fund) declined from a high of 79% post-market crash in 2009 to a low of 70% three years later (Exhibit 5). Interestingly, the average equity allocation crept back up as markets remained strong over the next few years. Today, the average equity allocation has rebounded to nearly 74%. This increase came as managers revised their long-term capital market expectations, which inform their strategic glide path decisions. It also reflects the competitive reality that more conservative glide paths have struggled to keep pace with their aggressive brethren during the prolonged U.S. equity bull market that began in 2009. Exhibit 5 80% Age 45 Equity Exposure 79% Average Equity Exposure 75% 70% 65% 76% 7 70% 71% 73% 74% 60% 2009 2010 2011 2012 2013 2014 2015 Calendar Year Plan Sponsor Considerations: Glide Path Changes Does a strategic change in the glide path significantly alter the return-risk trade-off of the glide path? If yes, is it still appropriate for the defined contribution participant base? What is the long-term strategic rationale for the glide path change? If there have been changes to the equity-to-fixed-income mix, has the composition of sub-asset classes within equity and fixed income also changed? Have glide path changes resulted in changes to the fee schedule, and are the changes reasonable? Knowledge. Experience. Integrity. 5
Additional Features: Asset Class Options In general, strategic allocations to less-common asset classes such as absolute return, commodities, non- U.S. fixed income, and emerging markets equity have increased. Exhibit 6 shows the overall average strategic allocation 3 to various asset classes for a 45-year-old participant (2035 fund). While allocations to these Exhibit 6 Age 45 Average Allocations to Various Asset Classes Large Cap Non-U.S. Equity Core Fixed Income Small-Mid Cap Emering Market Equity 5% 11% 13% 19% 38% Non-U.S. Fixed Absolute Return Commodities High Yield Global REITs TIPS Cash Equivalents 1% U.S. REITs 1% Exhibit 7 Prevalence of Various Asset Classes Across Glide Paths Large Cap U.S. Equity U.S. Fixed Income Developed Non-U.S. Equity SMID Cap U.S. Equity TIPS 68% 100% 100% 100% 96% Emerging Market Equity 61% Global REITs 50% High Yield Commodities Non-U.S. Fixed (Unhedged) 48% 46% 43% Cash Equivalents 36% U.S. REITs Emerging Market Debt 27% 25% Short Duration 25% Natural Resource Equity 21% Absolute Return 18% Bank Loans 9% Non-U.S. Small Cap Equity 7% Real Estate 5% Long Gov 5% Stable Value Non-U.S. Fixed (Hedged) 3 Allocations reflect strategic weightings; the actual allocations could be greater or less (see next section on the use of tactical management). 6
asset classes remain small, their presence in glide paths appears to be increasing. For example, while the average TDF offers just a 1.7% exposure to absolute return strategies, such strategies are now present in nearly one in five TDFs. 4 Of those providers utilizing absolute return strategies, the allocations ranged from 1% to 40% at various points along the glide path. As Exhibit 7 shows, active managers are expanding into hard-to-index asset classes such as emerging market debt (25.0%), bank loans (9.1%), and non- U.S. small cap (6.8%). Even direct real estate, which in the past bedeviled managers and plan sponsors with liquidity and valuation concerns, is present in a small number of TDFs. Plan Sponsor Considerations: Asset Allocation Are allocations to various asset classes meaningful enough to affect outcomes? What is the rationale for adding/eschewing a certain asset class? Are there asset classes a manager would like to include but cannot due to limitations like cost, lack of a proprietary product, lack of a relevant index, or other operational reasons? Are these limitations acceptable? Have allocation changes resulted in changes to the fee schedule, and is the change acceptable? Tactical Implementations: Air Bags or Nitrous? Tactical implementation goes by many names (i.e., dynamic strategies, active implementations, proactive strategies). Regardless of the nomenclature, these approaches all seek to add value whether by risk reduction or alpha generation through short-to-intermediate-term deviations from the strategic glide path. These tactical shifts should be differentiated from managers that deviate from their strategic weights due to market activity or cash flows. Instead, tactical implementations are characterized by intentional over- or under-weights relative to the TDF s long-term strategic allocations. When looking at the prospectuses for various TDFs, the allowable rebalancing ranges around the strategic weights often vary widely. A wide rebalancing range can prove beneficial if events beyond a manager s control necessitate extreme measures with regard to the underlying allocation. In some cases, managers will include language that allows them to allocate completely to cash in emergency situations. An examination of the aforementioned 44 managers prospectuses and offering documents (for collective trusts) reveals that the average range for those with tactical leeway in equities is +/-14%. Nearly one-third of all managers left the allowable range completely open-ended; 59% cited some degree of tactical management in their disclosure documents. Despite the range of tactical shifts allowed, in practice many managers rarely use their full tactical allowance. While the average allowable band might be +/-14% for those employing tactical management, the average absolute deviation 5 from the strategic equity weighting is 5.4%. If three outliers are removed, the average falls to 3.3%. As of June 2015, 58% of tactical managers were underweight their strategic equity benchmark while 40% were overweight. 4 The use of alternatives within TDF glide paths will be discussed in more detail in a follow-up paper. 5 The average deviation is the actual allocation (as of 6/30/15 or most recently available) versus the stated strategic weights. Knowledge. Experience. Integrity. 7
To see the potential impact on performance, consider the consensus 2020 fund. Exhibit 8 illustrates the effect on annualized returns resulting from shifting the equity 6 allocation, whether the manager makes a good call (2.5% bull market) or a bad call (97.5% bear market). The baseline scenario represents a manager remaining true to their strategic allocation. Exhibit 8 Effect of Equity Shifts on One-Year Performance Underweight Overweight Tactical Shift in Equity Equity Scenario Bear Equity Market 97.5% Bull Equity Market 2.5% Standard Deviation -14% -8.8% 19.4% 6.8% -10% -8.5% 22.5% 7.5% -5% -10.4% 24.8% 8.4% -3% -11. 25.7% 8.8% Baseline -12.3% 26.9% 9.4% +3% -13.1% 28.3% 9.9% +5% -13.6% 29. 10.3% +10% -15.6% 31.4% 11.3% +14% -17.1% 33.0% 12.1% For example, a 14% reduction in equity (relative to the strategic baseline) in a period where equity outperforms ( bull market ) would result in 7.5% underperformance relative to the baseline (19.4% versus 26.9%). Contrast this with the same 14% underweight to equity during the bear market, which would represent 3.5% outperformance relative to the baseline (-8.8% versus -12.3%). Modest tactical shifts can mean similar shifts in potential outcomes. Just as a manager can enhance the risk-return profile by taking equity off the table, they can also decrease the risk-return profile. This underscores the importance of understanding the extent to which a manager is employing tactical shifts and the purpose of these shifts. The fact that the actual deviation from the strategic allocation tends to be so much lower than the allowable deviation reflects the fact that most managers prefer to be conservative in this area. In other words, just as a car s speedometer may go up to 180 m.p.h., but few drivers will ever reach that level, few TDF managers expect to deviate very widely from their strategic asset allocation. Indeed, TDF managers often employ an internal risk-control structure based on maintaining fairly low tracking error. One manager recently explained that despite a 10% allowable range, a 3% move would exceed his internal tracking error limit; therefore, a move beyond 3% is not expected. Tactical overlays are often utilized for risk mitigation purposes or for modest return enhancement (i.e., 20-25 basis points of added returns). Even so, it is important not to downplay the role of tactical asset allocation in some TDF strategies as well as how new to tactical asset allocation some of these managers may be. 6 Equity increases in proportion to underlying allocation. Increases are funded from the allocation to core fixed income. 8
Indeed, with short track records and somewhat opaque return attributions, the implementation effects of tactical management remain somewhat nebulous. Exhibit 9 shows the glide path versus implementation return for a sample TDF manager ( XYZ ). While the glide path return is just the return attributable to a passive implementation of the strategic asset allocation, this implementation return will include the effects of active management as well as any effects of deviations from the strategic benchmark weightings. Exhibit 9 15% Glide Path Versus Implementation Return 10% A (56) B (65) B (51) A (52) 5% 0% A (12) B (23) -5% Last Last Last Year 3 Years 5 Years 10th percentile 4.25 12.94 12.91 25th percentile 3.30 12.38 12.60 Median 2.64 11.63 11.52 75th percentile 1.39 10.15 10.61 90th percentile 0.00 7.95 9.46 Manager XYZ A 4.10 11.32 11.34 Glide Path Return B 3.42 10.45 11.45 Implementation Return 0.68 0.87-0.11 Total Return Glide Path = + Return Implementation Return Beta from underlying asset allocation Alpha from active managers + effects of tactical shifts + any other implementation effects (rebalancing) In the case of Manager XYZ, the one-year total return of 4.10% exceeded the one-year glide path return of 3.4. This means that Manager XYZ added 68 basis points over the past year through implementation. Parsing the 68 basis points further would require a look at each underlying component of the target date series. Clearly, for such attribution analysis to be useful there must be a detailed understanding of the manager s strategic asset allocation. In other words, if Manager XYZ does not provide a complete set of custom benchmarks outlining the intended strategic asset allocation, it would be possible to confuse implementation return with the return attributable to the strategic asset allocation thus over- or understating Manager XYZ s value added. Examining how actual allocations have deviated over time from the strategic allocations and the magnitude of the deviations serves as a starting point. Additionally, the tools used to implement tactical Knowledge. Experience. Integrity. 9
shifts must also be understood. These tools vary from simply allocating to various underlying funds using cashflows and actual trading, to using derivative instruments to achieve the desired results. In the case of the latter, the precise nature of the instruments and the inherent leverage embedded (paying attention to the actual percentage of notional value posted) must be understood. Only after examining these factors should one claim to be comfortable with a manager s use of tactical management. Plan Sponsor Considerations: Tactical Management Does your TDF manager utilize tactical management? If so, what have been the historical deviations from the strategic benchmark weightings? What is the goal of the tactical component? Is there a stated return goal over time? How has the manager s tactical implementation performed historically? What is the decision-making process and the timeframe used to make tactical decisions? Does the manager have experience making tactical decisions? How are tactical decisions implemented? What is the track record of the tactical decision, and what is the associated cost? TDF Tuneup Plan sponsors should occasionally revisit their selection of a target date provider to examine how their provider s implementation decisions may affect potential outcomes. Useful best practices may be found in the Employee Benefits Security Administration s (EBSA) guide: Target Date Retirement Funds: Tips for ERISA Plan Fiduciaries (2013). EBSA s goal is to assist plan fiduciaries in selecting and monitoring TDFs and other investment options in 401(k) and similar participantdirected individual account plans. It lists eight key points: 1. Establish a process for comparing and selecting TDFs 2. Establish a process for the periodic review of selected TDFs. 3. Understand the fund s investments the allocation in different asset classes (stocks, bonds, cash), individual investments, and how these will change over time 4. Review the fund s fees and investment expenses 5. Inquire about whether a custom or non-proprietary target date fund would be a better fit for your plan 6. Develop effective employee communications 7. Take advantage of available sources of information to evaluate the TDF and recommendations you received regarding the TDF selection 8. Document the process The guide also references the Department of Labor s (DOL) 2012 participant disclosure requirements and points out that while TDFs are relatively new investment options, there are an increasing number of commercially available sources for information and services to assist plan fiduciaries in their decisionmaking and review process. Language like this suggests that from the DOL s perspective, a higher standard may apply to target date fund decision-making going forward than has been applied in the past. 10
Conclusion Just as a potential car buyer faces many choices when making a purchase, so too do plan sponsors when considering their target date options. Strategies may be active, passive, tactical, or strategic. The manager may offer different investment vehicles (e.g., mutual funds, collective trusts) each with its own criteria, pros, and cons. Each target date manager differs in their underlying philosophy, which shapes construction and implementation. The wide variety of options represents both a benefit and a challenge. As plan sponsors monitor target date funds and managers, they must examine any changes and assess how these changes may ultimately affect participant outcomes. In the next paper in this series, the conversation will move from the showroom and into the factory. We will move beyond the current landscape to examine target date construction how plan characteristics can inform choice and what the future of the target date landscape may hold. Knowledge. Experience. Integrity. 11
About the Author James Veneruso, CFA, CAIA, is a vice president and defined contribution consultant in Callan s Fund Sponsor Consulting group based in the Chicago office. Jimmy joined Callan in 2007 and is responsible for providing analytical support to Callan s DC clients and consultants including investment structure evaluations, fee analyses, and target date fund research. He is a regular speaker at the Callan College and various investment forums. Jimmy is a shareholder of the firm. Prior to joining Callan, Jimmy served over two years as a United States Peace Corps Volunteer in the Kingdom of Tonga. He served as project manager for the Future Farmers of Tonga program and taught at Queen Salote College. Jimmy received his master s in economics from University of Illinois and graduated with departmental honors earning a BS in computer science and economics at Vanderbilt University. He has earned the right to use the Chartered Financial Analyst designation and the CAIA designation. Jimmy is a member of the CFA Society of Chicago. If you have any questions or comments, please email institute@callan.com. About Callan Associates Callan was founded as an employee-owned investment consulting firm in 1973. Ever since, we have empowered institutional clients with creative, customized investment solutions that are uniquely backed by proprietary research, exclusive data, ongoing education and decision support. Today, Callan advises on more than $1.8 trillion in total assets, which makes us among the largest independently owned investment consulting firms in the U.S. We use a client-focused consulting model to serve public and private pension plan sponsors, endowments, foundations, operating funds, smaller investment consulting firms, investment managers, and financial intermediaries. For more information, please visit www.callan.com. About the Callan Investments Institute The Callan Investments Institute, established in 1980, is a source of continuing education for those in the institutional investment community. The Institute conducts conferences and workshops and provides published research, surveys, and newsletters. The Institute strives to present the most timely and relevant research and education available so our clients and our associates stay abreast of important trends in the investments industry. 2015 Callan Associates Inc. Certain information herein has been compiled by Callan and is based on information provided by a variety of sources believed to be reliable for which Callan has not necessarily verified the accuracy or completeness of or updated. This report is for informational purposes only and should not be construed as legal or tax advice on any matter. Any investment decision you make on the basis of this report is your sole responsibility. You should consult with legal and tax advisers before applying any of this information to your particular situation. Reference in this report to any product, service or entity should not be construed as a recommendation, approval, affiliation or endorsement of such product, service or entity by Callan. Past performance is no guarantee of future results. This report may consist of statements of opinion, which are made as of the date they are expressed and are not statements of fact. The Callan Investments Institute (the Institute ) is, and will be, the sole owner and copyright holder of all material prepared or developed by the Institute. No party has the right to reproduce, revise, resell, disseminate externally, disseminate to subsidiaries or parents, or post on internal web sites any part of any material prepared or developed by the Institute, without the Institute s permission. Institute clients only have the right to utilize such material internally in their business. 12
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