Ideally every plan investment would consistently deliver high returns with low risk and at low cost. In the real world, however there is always a tradeoff and this can present a difficult challenge for fiduciaries. How can we prudently select a target date fund or other QDIA option that delivers the most suitable tradeoff among returns, risk and cost for our specific plan? To answer that question we must first make sure that we are not overlooking or underestimating important risks.
In general, investors face two main risks, (a) the risk of losing our original investment and (b) the risk of earning such a low return that inflation makes us poorer in real terms. We cannot completely avoid both risks so instead we invest in a combination of equities (which carry the risk of capital loss) and fixed income assets (that carry inflation risk) and try to evaluate and manage the associated risks in the target date fund.
Risk measurements help us in this evaluation and they are often found in the financial pages provided by firms like Morningstar or a plan adviser’s investment report. The most common risk measurements are:
- Volatility, which gives us an indication of how widely an investments returns deviate from its long-term average;
- Sharpe Ratio, which provides a standard measurement of how strongly an investment out-performs a risk-free rate of return; and
- R-squared and Beta, which measure how systematically and how strongly the returns on an investment track those of a benchmark index. Alpha will tell whether the fund is outperforming the benchmark.
These risk measurements can be useful for a general investor but ERISA fiduciaries need to go further when evaluating their target date funds or QDIA option.
For example, better diversification not only reduces general portfolio volatility, it also reduces the risk of a sudden sharp loss due to specific fund risk. Perhaps that is why ERISA requires that “ a fiduciary shall discharge his duties with respect to a plan … by diversifying the investments of the plan so as to minimize the risk of large losses …” If the target date fund is over-weighted in a single investment, an issue presently under litigation, it faces a higher risk of unexpected loss that would not necessarily show up if a fiduciary is only measuring volatility. A prudent risk evaluation should include a reliable way to measure and monitor diversification, something that is sorely missing from most evaluation tools.
As recommended by the Department of Labor, Fiduciaries also need to “understand the principal strategies and risks of the fund, or of any underlying asset classes or investments that may be held by the (target date fund) TDF” and how these will change over time. As a fiduciary you need to know what percentage of the fund is invested in high-risk assets such as emerging markets, high-yield bonds, micro-cap stocks or derivatives. Are these and other risk exposures such as credit quality and duration stable over time or do they occasionally spike – which could indicate imprudent short-term risk taking to boost returns.?
Target date funds that use index options will closely track their related benchmark, with high R-squared and Beta values. However, if you focus only on comparing the target date fund to its benchmark, you could miss other risk exposures caused by the composition and dynamics of the underling benchmark itself. With so many indexes to choose from a fiduciary needs to prudently consider which index is most appropriate for their plan’s particular needs.
While plan fiduciaries will usually select an entire target date series from a single provider, it is essential to separately evaluate and look for hidden risks in each vintage. An overall series might score well in a generalized evaluation, it might have a specific vintage, for example 2025, that has performance problems relative to its competitors. This would be a bigger risk for a plan with a large percentage of older participants who would be expecting to retire in this target year. An evaluation tool that takes account of how much of the plan’s assets would be invested in each target year will help to identify and better manage this important risk.
All investments, including target date funds, have risk. As a fiduciary what is important is to properly identify, measure and monitor risks that could adversely affect the interests of your plan’s participants and beneficiaries. First identify in an unbiased manner what risks are most important, taking account of fiduciary priorities and participant demographics. Measure those risks for all candidate target date funds and then evaluate the tradeoff between each fund’s returns, fee levels and how well they are managing these risks.
Sound difficult – not at all! Ask your advisor to run a QDIA BLUE BOOK report so you don’t need to lose sleep wondering whether your target date option is too risky.
