Fred’s Take: When it comes to evaluating investments in defined contribution (DC) plans, HR and even finance people can get overwhelmed. With an estimated 70-80% of new contributions going into Target Date Funds (TDFs), primarily because it has become the most popular default option or QDIA (qualified default investment alternative), picking the right TDF is critical. But the selection and monitoring of a TDF is different than any other investment because it is a basket of investments and because of the longer time horizon of investors. Dorann Cafaro shows how plan sponsors can be misled by using the wrong data points when selecting a TDF and should spend more time evaluating whether it fits the profile and behaviors of the employees rather than just 1,3 and 5 year returns or Morningstar ratings.
Written By Dorann Cafaro
If you are involved in the selection of your 401(k) Plan’s investments you may be familiar with the pages and pages of data that seem to accompany any review or selection evaluation. Even if you just reviewed an investment factsheet, you realize it can contain an overwhelming amount of data to be evaluated. Consider this simple sample “A” below:
A: Fund Objective
This [highlight]target date[/highlight] investment seeks the highest total return over time consistent with an emphasis on both capital growth and income.
| Time | Performance: | +/- Benchmark | Rank in Cat | # funds in Cat |
| 1 yr | [highlight]-2.34[/highlight] | 2.78 | 14 | 242 |
| 3 yr | 8.54 | 4.14 | 4 | 201 |
| 5 yr | 9.26 | 2.89 | 3 | 169 |
| 10 yr | 6.17 | 0.87 | 1 | 77 |
| Sectors | % | Data | % | Fees | % |
| Technology | 13.91 | Tenure | 12 | Expense Ratio | [highlight]0.72[/highlight] |
| Healthcare | 15.51 | Assets | $23.1 B | % cash | 3.69 |
| Consumer Cycl | 13.99 | Credit quality | mod | % US stock | 48.36 |
| Industrials | 11.80 | Int rate sensitivity | low | % non-US stock | 27.25 |
| 3 yr beta | 0.97 | Stand Deviation | 8.23 | % bonds | 19.48 |
| 3 yr alpha | 1.23 | Sharpe Ratio | 1.03 | M* Rating | [highlight]5 stars[/highlight] |
With so much data it is easy to just look at the most obvious points (highlighted):
- Current performance
- Rating notation (number of stars)
- Style category
- Fees
This cherry-picked data may not be sufficient to evaluate the investment. For example current performance is not very useful when evaluating an investment that will be held in a 401(k) for long-term growth. But even if you perform an in depth review of the data how useful was it to your decision?
A few questions to consider:
- Did all this data tell you how suitable this investment was to your plan, your participants?
- Did all this data help you understand what investment criteria was more important to the plan or what investment criteria did not meet your plan’s needs?
- How useful was the generic rating, a rating applied under all circumstances for everyone?
- Would data designed to document the selection or monitoring of your personal plan’s investment process be more useful?
Consider how you would answer these questions if you had received sample “B” investment data below:
B: Fund Objective
This target date investment seeks to be the most suitable option meeting what criteria is important to this plan weighted as follows:
The importance weighting of your plan’s demographics is as follows:
| TDF Vintage Year | 2015 | 2020 | 2025 | 2030 | 2035 | 2040 | 2045 | 2050 | 2055 | 2060 |
| Demographics | 12% | 8% | 15% | 8% | 20% | 21% | 10% | 9% | 2 % | 0% |
| Suitability Rating vs All TDFs * | 100 | 100 | 100 | 100 | 99 | 100 | 93 | 94 | 100 | na |
* 100 = most suitable 0 = least suitable
The TDF Suitability Rank is #1 out of 122 target date funds evaluated for comprehensive 107 unique data measurements.
| Criteria with High Suitability | Higher absolute return, higher relative return, more stable returns, lower downside correlation, less risky asset allocations, more stable, risk exposures, greater equity diversification, lower expenses, longer manager tenure and higher AUM. |
Criteria with lower suitability Higher credit quality, and great inflation protection
