Evaluating Target Date Funds     ©2003 – 2013 Multnomah Group, Inc. All Rights Reserved.
Scott Cameron, CFAScott is the Chief Investment Officer for the Multnomah Group and a FoundingPrincipal of the firm. In th...
Agenda• Overview of Qualified Default Investment• Alternatives• Survey of the Target Date Fund Universe• Selection Methodo...
Qualified Default Investment Alternatives• Originated with the Pension Protection Act (PPA) of 2006• DOL’s objective was “...
Target Date Fund Universe                                                                   Target Date Series         Ass...
Selection Criteria                      Investment Management Firm                              Capabilities              ...
Investment Manager Firm Capabilities• Target date funds shift responsibilities to the fund manager from the  participant  ...
Firm Evaluation Criteria• How stable is the organization?    •       Target date funds are design to last a participant’s ...
Firm Evaluation Criteria (cont.)• Commitment    •   Does the firm have a dedicated staff for managing the target date fund...
Equity Glide Path100%     90%     80%     70%     60%                                                Bonds     50%        ...
Selecting an Equity Glide PathPlan Considerations                                  Fund Considerations• Employee demograph...
To RetirementInvestment Theses• Human-capital thesis     •   Maintain static risk exposure regardless of time horizon     ...
To Retirement (cont.)Glide Path Impacts• Reaches its most conservative allocation at the retirement date• Generally more c...
Through RetirementInvestment Theses• Mean-reversion of assets     •   Time horizon is most important factor to analyze    ...
Through Retirement (cont.)Glide Path Impacts• Equity allocation continues to decline after the target retirement date unti...
©2003 – 2013 Multnomah Group, Inc. All Rights Reserved.
Impact of Glide Path on Performance                     50.0                                                              ...
Asset Class Considerations• Which asset classes are included in the target date funds?• Do the funds provide sufficiently ...
Asset Class Components                                             Portfolio Diversifiers      Standard Asset             ...
Impact of Asset Classes on Performance                                                  2008 Return              2010 Fund...
Active / Passive Investment Management              • Seeks to outperform a benchmark   Active              • Value added ...
Active / Passive Management ConsiderationsActive Management                                  Passive Management• Evaluate ...
Active Management of Target Date Funds• Evaluated 32 active and hybrid  target date funds series with at  least 36 months ...
Proprietary vs Open Architecture     Proprietary Investment                 Open-Architecture                             ...
©2003 – 2013 Multnomah Group, Inc. All Rights Reserved.
Ongoing Monitoring Methodology• Has anything in our initial analysis changed?• Is the fund behaving consistent with expect...
Observed Investment Style                       XYZ       XYZ                              XYZ              XYZ    XYZ    ...
Performance Attribution                                              XYZ                  XYZ         XYZ                 ...
Peer Comparison                                             8 .0                                             6 .0         ...
5 Things Every Plan Sponsor Should Know• How capable is my target date fund management firm?• Is the equity glide path con...
DisclosuresMultnomah Group, Inc. is an Oregon corporation and SEC registered investmentadviser.Investment performance and ...
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Evaluating Target Date Funds

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Target date funds are quickly becoming the dominant investment option within many defined contribution retirement plans. Regulators have taken notice with the Department of Labor (DOL) contemplating new disclosure requirements for plans offering target date funds.

In order for a plan sponsor to meet their fiduciary obligations to prudently select and monitor their target date funds, a thorough analysis is necessary because of the underlying complexity of these products and their unique structure relative to the traditional "core" investment options that defined contribution sponsors are used to evaluating.

In this program, we present a framework for a sound fiduciary evaluation of a target date series.

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Evaluating Target Date Funds

  1. 1. Evaluating Target Date Funds ©2003 – 2013 Multnomah Group, Inc. All Rights Reserved.
  2. 2. Scott Cameron, CFAScott is the Chief Investment Officer for the Multnomah Group and a FoundingPrincipal of the firm. In that role, Scott leads Multnomah Group’s InvestmentCommittee, is responsible for the development of the firm’s investmentresearch methodology, and conducts investment manager due diligence. Scottalso consults with plan sponsors on investment menu design, investmentmanager selection, fiduciary governance, and vendor fees/services.Prior to founding the Multnomah Group, Scott was an investment consultantwith a national retirement services firm.Scott is a member of the CFA Institute, the CFA Society of Portland, theInvestment Management Consultants Association, and the Portland Chapter ofthe Western Pension & Benefits Council. Scott holds a B.S in Managementfrom Purdue University.2 Evaluating Target Date Funds
  3. 3. Agenda• Overview of Qualified Default Investment• Alternatives• Survey of the Target Date Fund Universe• Selection Methodology• Ongoing Evaluation Methodology• Questions3 Evaluating Target Date Funds
  4. 4. Qualified Default Investment Alternatives• Originated with the Pension Protection Act (PPA) of 2006• DOL’s objective was “…to ensure that an investment qualifying as a QDIA is appropriate as a single investment capable of meeting a worker’s long-term retirement savings needs.”• Final regulation outlined four categories of products that qualify as QDIA • A product with a mix of investments that takes into account the individual’s age or retirement date • An investment service that allocates contributions among existing plan options to provide an asset mix that takes into account the individual’s age or retirement date • A product with a mix of investments that takes into account the characteristics of the group of employees as a whole, rather than each individual • A capital preservation product for only the first 120 days of participation• QDIA regulations create safe harbor for plan sponsors meeting guidelines• Safe harbor does not eliminate the requirement for plan sponsors to prudently select QDIA optionhttp://www.multnomahgroup.com/resources/white-papers/white-paper-qualified-default-investmentSource: Employee Benefits Security Administration “Regulation Relating to Qualified Default Investment Alternatives in Participant-DirectedIndividual Account Plans”, April 20084 Evaluating Target Date Funds
  5. 5. Target Date Fund Universe Target Date Series Assets Market• First product launched in 1994 Share (%)• At the end of 2003 there were 16 Fidelity Freedom $114,126,954,422 32.5% target date fund series Vanguard Target $82,021,625,922 23.3%• Now there are 70 Retirement • 46 mutual fund series with $351 T. Rowe Price $57,640,732,683 16.4% Retirement billion in assets as of 1/31/2011 Principal LifeTime $17,701,660,326 5.0% • 20 collective investment trust (CIT) series (estimated assets of $41 Fidelity Advisor $12,606,531,646 3.6% billion as of 9/30/2010) Freedom • 4 insurance company separate Wells Fargo DJ Target $9,403,695,198 2.7% account series American Funds TD $9,230,869,912 2.6% Retirement TIAA-CREF Lifecycle $6,385,558,839 1.8% JHancock2 Lifecycle $4,901,728,109 1.4% Other $37,520,464,618 10.7% Total $351,539,821,675 100%Source: Morningstar and Ibbotson Target Maturity Report Q4 20105 Evaluating Target Date Funds
  6. 6. Selection Criteria Investment Management Firm Capabilities Equity Glide Path Costs Asset Class Selection Portfolio Management6 Evaluating Target Date Funds
  7. 7. Investment Manager Firm Capabilities• Target date funds shift responsibilities to the fund manager from the participant • Asset allocation is the responsibility of the fund manager • Security selection is the responsibility of the fund manager• Transitioning responsibility to the fund manager requires plan sponsor to gain deeper understanding of the investment management firm • Firm stability • Experience • Commitment • People • Process • Resources7 Evaluating Target Date Funds
  8. 8. Firm Evaluation Criteria• How stable is the organization? • Target date funds are design to last a participant’s lifetime (40-70 years) • Funds need to grow and adapt during that time period • New asset classes • Changing market dynamics • New investment research • Plan sponsors desire lower turnover of target date fund products compared to core fund options• What experience does the firm have in creating global asset allocation portfolios? • Most investment management firms are successful because of their single asset class funds • “Manager skill” is in selecting individual securities • Types of experience that is relevant • Outsourced pension investing • Investment consulting • Target risk investing • Target date investing • Is the asset allocation work done internally or outsourced to a third-party?8 Evaluating Target Date Funds
  9. 9. Firm Evaluation Criteria (cont.)• Commitment • Does the firm have a dedicated staff for managing the target date funds? • Are the target date funds a core product for the fund manager? • Have the products shown sufficient traction in the market to ensure long-term viability? • Does the fund manager demonstrate thought leadership within the target date universe?• People • What experience do the portfolio managers have with asset allocation funds? • How long have they been managing target date products? • Do they have any other responsibilities within the firm?• Process • Do they have a process for evaluating changes to the target date funds? • Have they managed investment products before? • Do they have a defined process for managing cash flows? • How do they handle rebalancing?9 Evaluating Target Date Funds
  10. 10. Equity Glide Path100% 90% 80% 70% 60% Bonds 50% Stocks 40% 30% 20% 10% 0% Age10 Evaluating Target Date Funds
  11. 11. Selecting an Equity Glide PathPlan Considerations Fund Considerations• Employee demographics • Fund sponsor’s investment thesis • Average income levels (To vs. Through) • Future wage growth • Beginning equity levels (farthest • Employee turnover from retirement) • Existing asset allocation • Transition period • Financial literacy • Slope of the glide path• Plan design • Terminal equity levels • DB / DC • Terminal equity date • Auto-features • Employer contribution levels • Employer stock• Fiduciary considerations • Knowledge level of the fiduciaries • Comfort level with risk11 Evaluating Target Date Funds
  12. 12. To RetirementInvestment Theses• Human-capital thesis • Maintain static risk exposure regardless of time horizon • Future earning and Social Security are bond-like • As an investor ages the present value of their future earnings declines so their financial capital (retirement account) should be adjusted to increase their bond exposure• Observed behavior thesis • Participants are not as rational as the forecast models imply • Analysis of acutual 401(k) participant behavior indicates large withdrawals at or near retirement • Greater uncertainty at the end-point • Objective is to get participants to the end-point rather than all the way through retirement12 Evaluating Target Date Funds
  13. 13. To Retirement (cont.)Glide Path Impacts• Reaches its most conservative allocation at the retirement date• Generally more conservative allocation across in the near retirement years• Funds merge into static allocation product at expected retirement year13 Evaluating Target Date Funds
  14. 14. Through RetirementInvestment Theses• Mean-reversion of assets • Time horizon is most important factor to analyze • Equity risk is minimized over longer time periods • Investors at retirement still have long time horizons• Equities are necessary to counter longevity risk • Market risk (volatility) is weighed too heavy relative to longevity and inflation risk • Higher equity exposure is necessary to provide sufficient retirement14 Evaluating Target Date Funds
  15. 15. Through Retirement (cont.)Glide Path Impacts• Equity allocation continues to decline after the target retirement date until sometime post-retirement (5-20 years after retirement date)• Equity allocations generally higher at retirement date compared against “to retirement” funds• Participants maintain their age-specific fund past the retirement date15 Evaluating Target Date Funds
  16. 16. ©2003 – 2013 Multnomah Group, Inc. All Rights Reserved.
  17. 17. Impact of Glide Path on Performance 50.0 38.92 40.0 33.34 30.0 27.95 20.0 12.76 Annual Return 10.0 0.0 2008 -10.0 2009 -10.75 -20.0 -30.0 -26.71 -40.0 -35.78 -38.80 -50.0 2010 Aggressive 2010 Conservative 2050 Aggressive 2050 Conservative Glide Path Glide Path Glide Path Glide PathThe Aggressive Glide Path represents T. Rowe Price Retirement funds and the Conservative Glide Path represents Wells Fargo Dow Jones TargetRetirement funds. 17 Evaluating Target Date Funds
  18. 18. Asset Class Considerations• Which asset classes are included in the target date funds?• Do the funds provide sufficiently broad exposure to global capital markets?• How did the fund manager determine which asset classes would be suitable for inclusion within the funds? • What modeling was done to determine the appropriate mix of asset classes? • Did the fund manager utilize capital market assumptions in their modeling? • Historical data? • Forecasted data? • What impact do the fund manager’s investment products play in determining asset classes? • Were asset classes excluded because the manager lacked a product? • Were asset classes included solely because a manager has a product in that class?• How frequently does the fund manager review the asset class structure of the funds? • Have their been any recent changes in the asset classes utilized by the funds? • Are they evaluating any future changes to the asset class lineup?18 Evaluating Target Date Funds
  19. 19. Asset Class Components Portfolio Diversifiers Standard Asset (Return Real Return Hedges Classes Enhancement / Risk Reduction) Stable Value Cash TIPS High Yield Bonds Intermediate Bonds Global Bonds Commodities Large Cap U.S. Equities Preferred Stocks Small Cap International Real Estate (REITs or Direct- Stocks Owned) Small/Mid Cap U.S. Equities Emerging Market Stocks International Equities Natural Resource Stocks Volatility19 Evaluating Target Date Funds
  20. 20. Impact of Asset Classes on Performance 2008 Return 2010 Fund A 2015 Fund B Difference Portfolio Portfolio Weight Weight Cash 2.06% 9.30% 0.00% -9.30% BC Credit Index -3.08% 11.80% 4.01% -7.79% BC Government Index 12.39% 5.84% 22.35% 16.51% BC Mortgage Backed Secs 8.34% 0.00% 8.13% 8.13% Index BC High Yield Corporate -26.16% 15.79% 2.90% 12.89% Bond Russell 3000 Index -37.31% 42.06% 49.87% 7.81% DJ US Select REIT -39.20% 1.98% 0.00% -1.98% MSCI EAFE -43.38% 13.24% 12.84% -0.40% Total Return N/A -30.27% -24.06% -6.21%Portfolio weights are calculated using a returns-based style analysis method using returns for the 36 months ended 12/31/2010 20 Evaluating Target Date Funds
  21. 21. Active / Passive Investment Management • Seeks to outperform a benchmark Active • Value added through the manager’s skill in timing the market or selecting Portfolio securities Management • Higher costs create a hurdle for the manager to outperform on a net-of-fees basis Passive • Seeks to provide market rates of return Portfolio • Portfolios try to track benchmark indices by replicating or sampling the index Management • Lower cost for portfolio management Hybrid • Utilizes a combination of active and indexed strategies Portfolio • May lower total cost of fund (not necessarily true) Management21 Evaluating Target Date Funds
  22. 22. Active / Passive Management ConsiderationsActive Management Passive Management• Evaluate usual criteria for selecting • Evaluate the usual criteria for active “core” managers selecting index managers • People • Costs • Process • Experience • Investment Philosophy • Tracking error • Costs • Does the target date fund provider • Capacity have access to a broad enough set• Active management adds a layer of of index strategies to provide the risk to the target date series asset class exposure that is desired?• What is the process for selecting the active managers?• How does the target date fund manager evaluate the managers?• What happens if a manager underperforms?22 Evaluating Target Date Funds
  23. 23. Active Management of Target Date Funds• Evaluated 32 active and hybrid target date funds series with at least 36 months of returns as of 12/31/2010 Alpha (36 Months through 12/31/2010)• For each fund we ran a Target-Date 2050+ returns-based style analysis model to calculate implied style exposures Target-Date 2041-2045 over the past 36 months• Using the returns-based style Target-Date 2036-2040 analysis results we calculated a customized “style” benchmark for Target-Date 2031-2035 each target date fund in the series Target-Date 2026-2030• Calculated “alpha” relative to the target date fund series Target-Date 2021-2025• Results Target-Date 2016-2020 • 3 target date fund series (9.375%) had positive average alpha Target-Date 2011-2015 • Highest average alpha was 0.864% annualized Target-Date 2000-2010 • Lowest average alpha was Retirement Income -5.798% annualized • Average alpha was -1.271% -2.00 -1.50 -1.00 -0.50 0.00 annualized23 Evaluating Target Date Funds
  24. 24. Proprietary vs Open Architecture Proprietary Investment Open-Architecture Hybrid Strategies Management Investment Management• All of the underlying • Target date fund • Sub-advised portfolios portfolios are managed managers utilizes outside • Fund manager utilizes by the target date fund portfolio managers to sub-advisers for a manager handle the security level portion of the portfolio• Most prevalent form of portfolio management target date funds responsibilities • Multi-boutique portfolios• May create perceived • Not very common • Target date fund conflicts between the • Open-architecture funds sponsor has multiple target date fund investors are more commonly independent and the fund manager structured as collective investments teams• May expose investors to investment trusts (CITs) • Each team maintains its highly correlated alphas • Adds an additional level own independent of fees to the funds investment • Open-architecture is not a research/strategy guarantee of higher performance24 Evaluating Target Date Funds
  25. 25. ©2003 – 2013 Multnomah Group, Inc. All Rights Reserved.
  26. 26. Ongoing Monitoring Methodology• Has anything in our initial analysis changed?• Is the fund behaving consistent with expectations given the market environment?• Are the portfolio managers adding value?• How do these products compare to alternatives in the market?26 Evaluating Target Date Funds
  27. 27. Observed Investment Style XYZ XYZ XYZ XYZ XYZ XYZ XYZ XYZ XYZ XYZ XYZ XYZ 2055 2050 2045 2040 2035 2030 2025 2020 2015 2010 2005 2000 1 0 0 .0 9 0 .0 8 0 .0 7 0 .0 6 0 .0 5 0 .0 4 0 .0 3 0 .0 2 0 .0 1 0 .0 0 .0 Cash B C A g g re g a te B o n d S m G ro w th S m V alue L g G ro w th Lg V alue D J U S S e l e c t R e a l E s ta te S e c s In d S & P D e ve l o p e d x U .S . B MI S & P E m e rg i n g Ma rke ts B MI27 Evaluating Target Date Funds
  28. 28. Performance Attribution XYZ XYZ XYZ XYZ XYZ XYZ XYZ XYZ XYZ XYZ XYZ XYZ 2055 2050 2045 2040 2035 2030 2025 2020 2015 2010 2005 2000 5 .0 4 .0 3 .0 2 .0 1 .0 Return % (Annualized) 0 .0 -1 .0 -2 .0 -3 .0 -4 .0 -5 .0 -6 .0 Cash B C A g g re g a te B o n d S m G ro w th S m V alue L g G ro w th Lg V alue D J U S S e l e c t R e a l E s ta te S e c s In d S & P D e ve l o p e d x U .S . B MI S & P E m e rg i n g Ma rke ts B MI A lpha28 Evaluating Target Date Funds
  29. 29. Peer Comparison 8 .0 6 .0 4 .0 2 .0 R e tu r n % ( A n n u a l i z e d ) 0 .0 -2 .0 -4 .0 -6 .0 -8 .0 0 .0 5 .0 1 0 .0 1 5 .0 2 0 .0 2 5 .0 S ta n d a rd D e vi a ti o n % (A n n u a l i ze d ) ABC 2050 ABC 2045 ABC 2040 ABC 2035 ABC 2030 ABC 2025 ABC 2020 ABC 2015 ABC 2010 6 0 % /4 0 % In d e x29 Evaluating Target Date Funds
  30. 30. 5 Things Every Plan Sponsor Should Know• How capable is my target date fund management firm?• Is the equity glide path consistent with our investment objectives and demographics?• What asset classes are included in our target date funds?• How is the portfolio management implemented?• How much do our target date funds cost?30 Evaluating Target Date Funds
  31. 31. DisclosuresMultnomah Group, Inc. is an Oregon corporation and SEC registered investmentadviser.Investment performance and returns are based on historical information and are nota guarantee of future performance. Investing contains risk. Some asset classesinvolve significantly higher risk because of the nature of the investments and thelow liquidity/high volatility of the securities.Any information and materials contained herein or on our website are provided forgeneral informational purposes only and are not intended to be comprehensive forany particular subject. Multnomah Group utilizes information from third partysources believed to be reliable but not guaranteed, and as a result, information isprovided to you "as is." We do not represent, guarantee, or provide any warranties(either express or implied) regarding the completeness, accuracy, or currency ofinformation or its suitability for any particular purpose. Multnomah Group shall notbe liable to you or any third party resulting from any use or misuse of informationprovided.Receipt of information or materials provided herein or on our website does notcreate an adviser-client relationship between Multnomah Group and you.Multnomah Group does not provide tax or legal advice or opinions. You shouldconsult with your own tax or legal adviser for advice about your specific situation.31 Evaluating Target Date Funds

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