Foreward to:
Evaluating Target Date Funds
By: Fred Barstein, Editor-in-Chief, 401kTV
401kTV Summary: Employers sponsoring a defined contribution (DC) plan like a 401(k) or 403(b) plan understand that they have a fiduciary responsibility to evaluate and monitor investments in their plans, which of course includes Target Date Funds (TDFs). But TDFs are different than any other investment and therefore should be evaluated differently as explained by long time plan advisor and now industry consultant Dorann Cafaro.
The process for evaluating these funds starts with an understanding of the needs, behaviors and demographics of the company as TDFs are designed to manage an investor’s entire portfolio in a DC plan whereas standalone funds are ingredients that investors can use to create their own portfolio. So plan sponsors are selecting a portfolio, or mix of assets that change as an employee nears retirement, for all employees in their workforce that use the selected TDFs.
HR Magazine published a comprehensive article on how TDFs work as well as their future. This article by Dorann is an excellent guide to help plan sponsors that use TDFs or are thinking of adding them to better evaluate which ones are right for them. Always best to consult with and work closely with your plan advisor.
Evaluating Target Date Funds
By Dorann Cafaro
Evaluating target date funds is a fiduciary duty. Target date funds are not new; they have been around since the early 1990’s when investment management firms introduced a single asset allocation investment that evolved over time to meet participant’s changing needs. However it was the release of the PPA 2006 regulation that dramatically increased cash flow to these options to meet the QDIA requirements. This dramatic increase in assets has also increased a plan sponsor’s liability. The selection of a QDIA is a fiduciary activity so if the QDIA is a target date investment (TDF) than it is obvious that the selection and monitoring of this TDF is a fiduciary activity. What one may not realize is that Department of Labor’s focus on TDFs after the 2008 market downturn exceeded just TDFs used as the QDIA, rather they delivered very thorough guidance to Plan Fiduciaries regarding what fiduciaries must consider for the selection and monitoring of TDFs without regard to whether they were identified as the QDIA. The DOL spelled out the fiduciary duty steps for evaluating all TDFs.
Evaluating target date funds is very challenging. These are investments that have many moving pieces impacting the investment itself. The asset allocation are constructed on glide paths, a changing asset mix over time, and can be very unique thus making it hard to compare and difficult to benchmark with traditional methods. The investment structures are often very complex and may not be very transparent thus we have seen some very poor performing fund-of-funds hidden inside a TDF. The investments can be passive, active or a mixture of both thus making it hard to compare. In addition the asset allocation may shift from the published allocation reviewed at the time of selection. TDFs also have challenging fee structures making it hard to understand the true fee. For example some TDFs have unique fee rebates to the record-keeper for proprietary options. To properly evaluate TDFs the risk parameters need to be understood and compared yet they are so different it is very difficult to pull out the comparative critical risk data. Plus the marketing information may incorrectly describe the risk features with marketing terms like “to” or “through” to indicate the risk near retirement. With all of these challenges how can a fiduciary meet their duty to evaluate and monitor?
Start with considering the guidance provided by the DOL. Step one is to establish a process for comparing and selecting the TDF. Then establish the process for reviewing the selected TDF and document these processes. The process must permit the fiduciary to understand the details of the underlying investments in the TDF, to understand the allocation structure and any changes to the allocation, to understand the details of the investment diversification and to understand the fees. And the process must permit the consideration of custom or non-proprietary TDFs. The traditional evaluation process has drawbacks to meeting this DOL directive. The traditional investment evaluation process often fails to document how the short list was determined; it often focus on only a few features like the glide path, fees or performance and excludes all the attributes which should be considered thus not reflecting the complexity of the investment structure while failing to consider the impact of risk criteria. Also many traditional evaluation methods use a filtering process that may exclude excellent candidates and the filters may use marketing labels that are not supported by the data. Thus there has been a proliferation of third party tools to fill the need, however some may only include a limited comparative platform using even more limited data and they often biased in their methodology to the providers’ philosophy.
To best meet the DOL guidance fiduciaries should start with determining what TDF criteria is important for their specific plan. Is it more important to reduce risk or have higher relative performance? Both are important but which is more important? They must consider all criteria from expense, manager tenure, assets-under-management, relative and absolute performance, equity diversification, fixed income features such as credit quality and duration, lower correlation and stability of returns. They should not limit the evaluation to a selected few criteria. They should incorporate the plan’s demographics reflecting the importance of certain TDF vintage years for their population. Thus a young demographic profile might need to place greater importance on later vintage years. The process should be fully transparent, use a comprehensive assessment of the underlying investments and must be repeatable. It should permit all TDF options to be compared and evaluated side-by-side whether a proprietary option or a custom option. This can be done quickly and without biased using the QDIA Blue Book tool. The tool will produce a report documenting the process meeting the DOL guidance including the importance weights for each of 39 attributes (107 data points) and can disclose the suitability of each criterion in relation to all available TDFs and specifically to another under consideration. It can reveal the criteria’s strengths and weaknesses both against all available TDFs and specifically against a chosen comparable option. It cannot only document the selection process but also the monitoring process providing key early warning information of deteriorating suitability for the selected TDF.
