EVALUATING TARGET DATE FUND STRUCTURE WHITE PAPER … DECEMBER 2010Scott Cameron, CFAPRINCIPALTarget date funds are in the crosshairs of some members of Congress, as well as the Department of Labor(DOL) and the Securities and Exchange Commission (SEC). In fact, the DOL just announced proposedmodifications to the qualified default investment alternative and participant disclosure regulations that wouldmandate increased disclosure for these products. Much of this focus stems from the increasing popularity oftarget date funds, as well as their perceived failure to protect investors during the most recent bear market.Target date funds became hugely popular following the passage of the QDIA regulations because of the implicitgovernment endorsement of these types of products and the relative ease of use and communication for mostplan sponsors. It was very easy to tell participants to just select the option that is closest to when they will turn65, or want to retire, and they would not need to worry about anything else. Unfortunately, in hindsight, thetiming of the QDIA regulations and the adoption of these products was extremely poor in that most sponsorswere adopting these funds at the heights of a bull market.In the bear market of 2007-2009, target date funds behaved mostly as one would have expected given thatthey were invested in the stock and bond markets. These funds, to varying degrees and for a variety ofreasons, experienced losses that caused concern among participants, plan sponsors, members of Congress,and regulators. Some of the criticisms that these funds received are well-founded, while others are derivedfrom a lack of understanding of the nature of these products, how they work, and what composes theirunderlying investments. Never were these products designed to provide any guarantee of principal at theretirement date, nor any guarantee of retirement income for those invested in the funds. Instead, they weredesigned to invest in an underlying portfolio of stocks and bonds that the fund manager thought wasappropriate for the average investor of that age. As the fund aged towards its target retirement date, theunderlying portfolio would become more conservative automatically to account for investors’ shorter timehorizon and the assumption of a more conservative risk tolerance.The QDIA regulations created fiduciary protections for plan sponsors and enabled them to create betterretirement solutions for their participants. Unfortunately, some plan sponsors thought it also relieved them ofthe responsibility for selecting and monitoring the QDIA product that they selected. The DOL has made clearthat “The final regulation does not absolve fiduciaries of the duty to prudently select and monitor QDIAs.” 11 Employee Benefits Security Administration “Regulation Relating to Qualified Investment Alternatives in Participant-DirectedIndividual Account Plans”, April 2008.
EVALUATING TARGET DATE FUNDS … 2In order for a plan sponsor to meet their fiduciary obligations to prudently select and monitor their target dateQDIA funds a thorough analysis is necessary because of the underlying complexity of these products and theirunique structure relative to the traditional “core” investment options that defined contribution plan sponsors areused to evaluating. At the most basic level plan sponsors need to evaluate the following characteristics of theirtarget date fund series: • Investment Management Firm Capabilities (Firm Stability, People, Process) • Equity Glide Path • Asset Class Selection • Investment Management Implementation • Investment CostsInvestment Management Firm Capabilities (Firm Stability, People, Process)It is difficult to overstate the importance of the investment management firm in the analysis of a target date fundseries. In addition to being responsible for the individual security selection within the component vehicles, theinvestment management firm is taking on additional responsibility with respect to the appropriate assetallocation for the participants invested in their funds, as well as the appropriate asset classes to include in adiversified portfolio for each participant. With this increase in responsibility comes the need for plan sponsors tobetter understand the capabilities of the firm they are selecting and the resources they have to develop andsupport their product. Plan sponsors should favor investment managers with experience in creating globalasset allocation portfolios or investment managers that have outsourced the asset allocation decisions to acompetent third party with experience in asset allocation.Most traditional asset managers have historically focused on creating individual investment products that aretargeted to single asset classes. Their unique skill is in identifying and selecting individual securities that willoutperform their respective benchmarks. For firms with this background, the creation of a target date seriesrequires additional skills in asset allocation that are not necessarily easy to develop.Target date funds are designed to be a single investment option that is appropriate from the time an investorenters the workforce and starts saving for retirement all the way up to, and in some cases, through theirretirement. Because of the expected longevity of these investment vehicles, and the expectation that plansponsors do not want to shift target date fund series every few years to chase better products, it is importantthat the investment management firm be fully committed to their product. Commitment to the target date fundseries shows up in the form of dedicated investment professionals focusing on managing the target date funds,fully developed research supporting their construction methodology, and a minimum level of asset scale withinthe products.Resource commitment is also essential because of the dynamic nature of these products over their expectedlife. In the 7 or 8 years since these products started to become popular we have already seen changes in theequity glide paths of funds, as well as the asset classes that are included within the fund series. Contrary tohow these products have been marketed, our expectation is that these funds will change over time to adjust tochanging global capital markets and improved investment research. Understanding the need for these funds to
EVALUATING TARGET DATE FUNDS … 3change over time, it is important that the investment management firm have the ability to continue to improvetheir product with new research and best practices.Ultimately, the evaluation of the investment management firm comes down to the people and processes.Experienced employees working in a stable work environment, with minimal turnover, should have theintellectual capital necessary to successfully manage these products over their lifetime. Supporting theseindividuals should be sound investment and operational processes that allow the investment professionals tomeet the funds’ investment objectives while ensuring compliance with all applicable rules and regulations.Equity Glide PathThe first, and most important, decision an investment manager has to make in constructing a target date seriesis the selection of an equity glide path for their funds. Equity glide path is a term used to describe a fund’schanging allocation to stocks and bonds over its expected lifetime. All target date funds start their life with themajority of their assets allocated to equity investments, and as they get closer to the targeted retirement datethey decrease the equity allocation and increase their exposure to fixed income investments.Because of the difference in expected return and risk of stocks and bonds, differences in the equity glide pathof competing funds will be one of the primary reasons target date funds have differing returns over time. At thispoint, and it seems unlikely to change in the future, the investment management industry has not settled on asingle, appropriate glide path. Because of this, products that on the surface appear to be similar (two 2025funds would generally be assumed to have the same investment objective), may in fact be markedly different intheir composition, expected return, and volatility.The DOL recognizes the important of equity glide path in the overall construction of target date products. Theirrecently released proposed regulations would require greater disclosure for these products, focusing onproviding more information, both written and graphical, regarding a fund’s equity glide path and how it changesover time.To Versus Through RetirementWhile equity allocations differ among target date providers across all maturities, the largest differences appearas participants near the targeted retirement date. These differences are most impactful to investors because itis at the stage where investors are nearing retirement that they generally have the largest account balance andtherefore have the most at stake with regards to the performance of their investments. The differences in equityallocation as funds near retirement is a result of each investment manager defining their investment objectivesdifferently, making different assumptions about the market, and weighting the individual risk factors (i.e. marketrisk, longevity risk, sequential risk, inflation risk, etc.) differently.At the most basic level, differences in equity allocations near retirement are attributable to the “to versusthrough” retirement choice. Funds that are managed “to” retirement have a declining allocation to equities upuntil the target retirement date and settle into a static, conservative asset allocation after the target date. Fundsmanaged “through” retirement have an equity allocation that continues to decline after the target retirementdate and settles into a static asset allocation at some point beyond the retirement date.
EVALUATING TARGET DATE FUNDS … 4The “to versus through” debate is somewhat of a flashpoint in the larger debate over the use and structure oftarget date funds within defined contribution plans. It serves as short-hand for a deeper, more nuanced analysisof the differences amongst the various products in the market. On the surface, the debate is about theappropriate structure of a fund’s glide path (the changing allocation to stocks and bonds over the fund’sexpected lifetime). Digging a little deeper, this debate is a proxy for the larger one about the appropriate level ofrisk and equity exposure in these funds over their projected lifetimes.Those in favor of a “to-retirement” glide path believe that the allocation should reach its most conservative pointat the target date and stay static for all time periods after that date. Those in favor of a “through-retirement”glide path believe that the allocation should reach its most conservative point at some point (generally 10-20years) after the target date and stay static for all time periods after that date. Because these funds havediffering time horizons with respect their glide paths’ landing points, “to-retirement” series are generally moreconservative in the years leading up to the retirement date.In addition to the need to reach the landing point sooner, “to-retirement” managers generally define theinvestment problem differently than “through-retirement” managers. They focus more on short-term market risk,the protection of principal, and the desire to minimize the variability of outcomes among participants. “Through-retirement” managers generally focus more on maximizing retirement balances and managing to minimizeinflation and longevity risk, even if it means somewhat higher exposure to short-term market risk.While both sides argue their points passionately and persuasively, the market has shown this to be a very one-sided argument so far. According to a recent Morningstar research paper, the top 5 target date series of mutualfunds account for over 85% of the assets invested in target date mutual funds. Of these 5 series, all are“through-retirement” funds. It is likely that this practice will continue given the investment firm’s interest inretaining assets “through-retirement.”Asset Class SelectionAfter the selection of the equity glide path, or as part of the equity glide path development, the investmentmanager needs to determine which asset classes are appropriate to include within the portfolios’ allocations. Atthe most basic level, each series generally includes allocations to cash investments, investment gradedomestic bonds, domestic stocks, and international stocks.The selection of appropriate asset classes should be dependent on a set of capital market assumptionsdeveloped by the investment manager that focuses on the risk, return, and correlation of each asset class.Based on the capital market assumptions the investment manager should select asset classes that whencombined together provide the highest expected return for the lowest level of risk.Asset class inclusion is one area that has seen the most change over the past few years. While most of thesefunds initially launched with allocations to the basic asset classes mentioned above, investment managers arebecoming more sophisticated in the portfolio construction by adding new asset classes to their target dateportfolios. The primary examples of this are managers including more inflation sensitive assets within theirportfolios (TIPs, commodities, REITs, and in some cases direct real estate) as well as expanding the breadth of
EVALUATING TARGET DATE FUNDS … 5their international exposure (international fixed income, developed international small cap equities, andemerging market equities).Investment Management ImplementationOnce the glide path and asset allocation have been set, the investment management firm is responsible forselecting the individual investment managers to implement the funds’ design. Most target date funds are fund-of-funds with the target date fund allocating its money to individual funds investing in a single sub-asset class(i.e. U.S. large cap growth stocks). For target date fund managers, the choice for investment managerimplementation differs along two dimensions: active/passive and proprietary/open-architecture.Most investment managers are either active or passive in their investment style. Only a handful of the largestinvestment management firms (Vanguard, Fidelity, BlackRock) offer both actively managed and passivelymanaged index-based funds. This bias at a firm level generally flows through to the target date fund series ofthe management firm. If they offer actively managed funds, their target date funds are actively managed, andvice versa.Recently we have seen more investment managers adopting a hybrid approach to their target date fund series.In this hybrid approach, they are investing in a combination of active and passive mandates for the underlyingfunds. The hybrid approach is gaining traction because for even the best active managers, the ability to addvalue in each of the underlying asset classes included in a target date fund is difficult. These active managersare identifying which asset classes they have a unique ability to add value, actively managing those assetclasses, and using passive mandates in the remaining asset classes. With this strategy underperformance intheir non-core asset classes is minimized and does not dilute their “active” value added in their core assetclasses. The hybrid approach also is being implemented because of its ability to drive down the total cost of thefund series.Besides the active/passive dimension, target date fund series differ in whether they consist of only proprietaryfunds or if they are open-architecture investment options. The vast majority of target date funds use proprietaryinvestment options from the target date funds’ investment manager. The concern with proprietary investmentoptions is that the target date fund manager is limited in their selection of managers only to what they haveavailable within their fund family. For smaller fund families, or fund families with a distinct investment style thatis homogenous across all of their products, this can be a real limitation for the target date fund manager. Forlarger firms, this might be less of a problem, although any artificial limits on the universe of investment productsavailable to the target date manager cannot be viewed as a positive item.There are arguments for proprietary investment management within target date funds. It is generally safe toassume that proprietary fund options are better well-known to the target date investment manager, enablingthem to better understand the strengths and weaknesses of each fund, its investment process, the peoplemaking the security selection decisions, and how their investment strategy might fit with the other strategiesused by the target date fund. The use of proprietary funds also minimizes the number of parties involved in thefunds, potentially reducing the total costs of the investment products.
EVALUATING TARGET DATE FUNDS … 6While most target date options utilize proprietary funds within their target date series, there are multiple targetdate series that utilize an open-architecture approach to investment management. In these funds, the targetdate fund managers is responsible for the glide path, asset allocation, and selection of outside moneymanagers, while the outside money managers invest in the individual securities per their mandate from thetarget date fund manager. Open-architecture products have the advantage of having access to a broader arrayof investment managers, the ability to identify “best-in-class” managers for each asset class, and the lack ofappearance of a conflict that can exist for a proprietary fund solution. On the downside, open-architecturetarget date series are less common in mutual fund form (generally they are more readily available as collectiveinvestment trusts) and they include an additional layer of management that might make them more expensivethan a proprietary solution. Finally, it is important to note that open-architecture by itself does not guarantee thefunds will outperform proprietary solutions. The target date fund sponsor still needs to be successful inidentifying managers that will outperform, not necessarily an easy feat for anyone.Besides making the decisions regarding active/passive and proprietary/open-architecture, the implementationof investment managers is an area of broad discretion for the target date fund manager with both positive andnegative results. Fund managers have the ability to seek out the best-in-class options within their fund family orthey may veer towards investing in other funds within their investment lineup that have been overlooked by themarket. As these products become more sophisticated, we are seeing target date fund managers move awayfrom investing in a handful of retail fund options that the manager already sponsors, and creating more custom,institutionally focused investment options that are used by the target date funds.Investment CostsThe costs for managing these products create a headwind that can negatively affect investors’ ability toaccumulate a sufficient retirement nest egg. Because of this, investment costs are important component of anytarget date fund analysis. For actively managed funds, plan sponsors should be evaluating the fund manager’sability to add value in excess of the fees they charge for managing the portfolio. If it is unlikely that they cannotoutperform on a net of fee basis, one should question whether it makes sense to use an actively managedproduct.MULTNOM AH GROUP’S VIEWWe continue to be strong proponents of target date funds within defined contribution plan investment lineupsbecause of their ability to create diversified, balanced portfolios for those participants who are unwilling, orunable, to manage their retirement plan investments. While we believe in the virtue of these products, we arecognizant of their faults and weaknesses. In particular, there has been too much emphasis on proprietarysolutions (both within the target date fund portfolio and with relationships between recordkeepers and assetmanagers), a lack of clarity with respect to glide path construction and the research supporting the chosen glidepath, and a failure on the part of a large majority of the actively managed products to add any value net of theirfees.
EVALUATING TARGET DATE FUNDS … 7These products are still relatively young and it is our expectation that the industry will continue to evolve andimprove these products over time. It starts with plan sponsors and participants demanding better solutions, andfund companies adjusting to learn from their mistakes and to provide better solutions for their clients. We arealready seeing bundled recordkeeping providers opening up their platform to outside target date fund families(even for smaller plan sponsors) and more open-architecture and hybrid active/passive solutions coming to themarket.We do not believe that there is a single, optimal glide path for all plan sponsors, nor do we even believe thatone side is right in the “to versus through” debate. Each plan sponsor needs to evaluate their specific needs toselect a solution that best meets their investment objectives. Reasonable plan sponsors should begin byunderstanding themselves and their plan, its demographics, the income needs of their participants, theinvestment savvy of the participant population, and the objective for offering a target date fund series. Based ona thorough understanding of their own situation, they need to evaluate the alternative products available, thestrengths and weaknesses of the investment managers, the stability of the investment managementorganization, the research and theory that went into the construction of the equity glide path and the assetallocation, which managers will be used to invest the portfolio, and the investment strategies that they willutilize to select the individual holdings.The depth of analysis that is required can be daunting, but is necessary to ensure participants achieve theoutcomes they expect and plan sponsors meet their obligations to the plan. This type of analysis does not lenditself well to the simple peer group comparisons and historical performance analysis that is commonly utilizedto select other funds. Instead, it requires plan fiduciaries to dig deeper into their understanding of theirinvestment objectives and the products that they utilize. If done successfully, plan fiduciaries can enable betteroutcomes for the participants that they serve; if done poorly, it can result in institutionalized performance-chasing that ensures perpetual underperformance.Multnomah Group, Inc.Phone: (888) 559-0159Fax: (800) 997-3010www.multnomahgroup.com† This White Paper is not intended to be legal advice and should not be construed as such. Information relayedherein is representative of the Multnomah Group’s experience and current understanding of the law. While theMultnomah Group has made every reasonable effort to ensure that the information contained herein is factual,we do not warrant its accuracy. Additionally, this White Paper does not embody a comprehensive legal study,but rather reflects the information most often sought by our clients. As the information contained herein isgeneral in nature, you are urged to contact your legal adviser with specific questions related to your plan.