How to Vet Target-Date Funds

Target date funds (TDFs) differ significantly in terms of asset classes, glide path, fulfillment, and fees. It is a rich variety to choose from and at the same time may add to one’s perplexity. So, how do plan sponsors evaluate a TDF series?

In this piece, we discuss the predictability of fund performance based on ratings, tips from the Department of Labor (DOL), and our views on overlooked factors in evaluating TDFs. The DOL tips set up a framework that seeks to align investment strategies with employee demographics.

Summarily, plan fiduciaries should define investment strategies based on the plan’s objectives and evaluate the asset managers’ process to meet these stated objectives. Fund performance and fees, which are certainly important and often receive the lion’s share of focus for many fiduciaries, should not be the only factors that dictate the evaluation and retention of a target-date fund.

Manager selection based on ratings

Can you select an asset manager based on a third party’s ratings?

The Wall Street Journal had this headline: “investors everywhere think a 5-star rating from Morningstar means a mutual fund will be a top performer – it doesn’t.”[1]

It found that only a fraction of those funds that were awarded a top rating performed well enough over the next five years to maintain that rating; some performed so poorly that they ended up with a rock-bottom one-star rating. Morningstar defended its analytical value by saying that five-star funds tended to maintain higher ratings than four-star funds over the time period studied, and so on, which is “tilting the odds in investors’ favor.”[2]

The debate thus continues. In the context of academic research, the Journal’s investigation isn’t pioneering but it reminds investors that past performance is no guarantee of future outcomes.

Selection of Strategies based on objectives and process

The DOL offers helpful tips for the selection and monitoring of target-date funds and suggests plan fiduciaries do the following:[3]

Establish a process for comparing and selecting target-date funds,
Establish a process for the periodic review of target-date funds,
Understand the fund’s investments,
Review the fund’s fees and investment expenses,
Inquire about custom or non-proprietary target-date funds,
Develop effective employee communications,
Take advantage of available sources of information, and
Document the process

The DOL document is a good source of information and education for plan sponsors and fiduciaries. The tips are worth a careful read. We offer some additional thoughts below.

It is clear that, from these tips, fiduciaries need to define objectives they expect to achieve for the plan constituents. This is by no means equivalent to seeking returns to beat an exogenous (or often irrelevant) index benchmark. Rather, there has been a shift of focus towards generating adequate retirement income for participants. The objectives should be in line with participants’ demographic and economic characteristics. Their specific retirement goals can be calibrated by analytical tools and should be reflected in investment strategies.[4] The fit should therefore be judged by how well the portfolios will fund such expected liabilities (spending needs in retirement) and whether the risk-taking is measured and not excessive.[5]

Given the continuing duty to monitor investments, fiduciaries need to review changes in the philosophy and management of the investment provider. Likewise, changes in plan provisions and population (as induced by mergers and acquisitions, for instance) are opportune times for fiduciaries to revisit the suitability of strategies.

Plan sponsors will quickly notice that there are multiple glidepaths for them to choose from, including different categorizations of asset classes, aggressive, moderate, vs. conservative asset allocations, and “to” vs. “through” retirement. It is critical to think through the reasons behind the design. For instance, does the glide path have sufficient diversification?

Does it reflect workers’ varying risk-taking capacities and appetites at different life stages? Does it generate an appropriate amount of returns to solve for the projected liability at retirement? We believe these are several factors often overlooked by plan sponsors.

Fees are a major theme for DC plans. Litigation risk adds to fear.

Discussions are often anchored there and overshadow a holistic view of success factors for a retirement plan. However, an average worker’s wealth upon retirement could be primarily attributable to persistent savings (68%) and investment outcomes (38%), while a portion (6%) could be chopped off by fees, which is perhaps a significantly smaller erosion than many feared.[6]

The DOL says “don’t consider fees in a vacuum.”[7] The U.S. District Court in Minnesota nodded. A low-cost mandate should not simply morph into easier-to-implement asset classes, less professional expertise, and services, or insufficient diversifications among key areas and markets.

A common critique of off-the-shelf TDFs is that the one-size-fits-all approach may no longer be appropriate if the plan has a population of heterogeneous investors. Plan sponsors in this case may wish to consider customizing the solution at the plan level or personalizing it for each individual. Retirement savings and investing are complicated and evolving, while workers’ financial literacy and skills are limited in general.

This calls for help from an investment manager who understands participant behavior to develop solutions (including effective communications) and nudge workers towards better outcomes. More spot-on services and advice would be provided, and a customized or personalized strategy could be a better fit for the plan.

A savvy asset manager would also assist the plan fiduciaries to document plan goals, investment policy, due diligence, and ongoing monitoring efforts. This is best practice and keeps evolving investment committee members educated and informed with all the careful considerations and reasons behind decisions.

Conclusion

Fund performance alone is not a sufficient prerequisite for retirement plans to select or reject a fund manager; fees are important but should not supersede other considerations either, as indicated by the DOL tips and court rulings. Rather, plan fiduciaries need to define their plan objectives and establish a process to evaluate, select and monitor investment strategies.

Granular things aside, sound plan governance clearly stood out as the critical determination of fiduciary competency. This encompasses a prudent decision-making and selection process, avoidance of self-interest, and continued monitoring, in order to ensure that fund options are appropriate for the retirement plan.

[1] The Wall Street Journal, “The Morningstar Mirage,” October 25, 2017.

[2] Morningstar, “A Message from the CEO,” October 25, 2017.

[3] 3 Department of Labor, 2013, “Target Date Retirement Funds – Tips for ERISA Plan

Fiduciaries.”

[4] Northern Trust, 2017, “How Much Retirement Savings Is Enough?”

[5] Northern Trust, 2017, “What’s the Funding Status of your DC Plan?”

[6] Pang, Gaobo. 2016. “Fear of Fees in Defined Contribution Plans.” Journal of Financial

Planning 29 (7): 46–51

[7] U.S. Department of Labor. August 2013. “A Look At 401(k) Plan Fees.”