Target date funds have entered their third decade of existence, but what’s made these investment options even more popular recently is their acceptance as a retirement plan’s qualified default investment alternative (QDIA).
During the past 20 years, investors have become more aware of the distinctions between approaches, philosophies and structures of each of the target date fund families. You can bet that each of the more than 50 target date fund families believe they do things differently than their competitors.
One of the key distinctions between target date fund families is their approach to glide-path design: how the fund becomes more conservative over time. Such distinctions include the rate a fund reduces equity exposure, the time that the equity exposure in a fund is held static, and the ending allocation to equities at a retirement date. The industry has coined these differences as “to retirement” and “through retirement.” “To retirement” funds are more conservative than “through retirement” funds.
The Department of Labor (DOL) has recognized these distinctions, the conflict of interest of proprietary mutual funds, as well as the huge asset base that these funds have attracted since becoming the qualified default investment alternatives. The DOL issued “tips” in 2012 to plan sponsors regarding the selection and monitoring of target date funds.
The DOL’s tips include evaluating the fit of the target date fund based on the plan sponsor’s organization and the demographics of the specific plan participants. Key considerations include participant behavior, as well as committee philosophies and preferences in selecting the target date funds. But it doesn’t stop there. Composition of the target date funds, glide path, manager tenure and experience, reasonableness of expenses and performance over time should also be evaluated. While seemingly a very complicated and challenging task, Innovest has created a process to assist plan sponsors.
The first step in our process is to analyze participant demographics. To do this, we partner with our client’s record-keepers to gather information such as the number of participants by age, average salary by age, average contribution rate by age, average age at hire and retirement, and the percentage of participants who keep their money in the plan after retirement. Once we collect this information we incorporate other eligible retirement benefits of the employer, such as defined benefit plans, mandatory plans, Social Security eligibility, and combine these factors to create a baseline demographic report. The data and metrics of demographic analysis are imperative when selecting target date funds. A plan with participants who have high average salaries, high contribution rates, and participate in Social Security may be able to select more aggressive target date funds compared to a plan with participants who have lower average salaries, low contribution rates and do not participate in Social Security.
The next step is to collect committee preferences. We utilize a computer-based survey tool to collect their perspective on the purpose of the plan, preferences for active or passive investment management, opinions on a “to” approach to managing the glide path vs. a “through” approach, as well as at what date the glide path’s asset allocation should become stable.
As you can likely imagine, this screening process is less quantitatively focused and more qualitatively focused. Given the equity market’s overall rise in recent years, returns of “to retirement” funds have underperformed “through retirement” funds. If a consultant were to simply screen or compare target date fund families solely on performance, odds are very high that, depending on the most recent market environment, the objectives and design of the target date funds would not meet the client’s objectives.
All of these data points are combined into in a comprehensive analysis to identify the two or three best-fit target date fund families that will meet our client’s objectives. This custom approach helps ensure that the qualified default alternative of the plan meets the objectives of both the plan sponsor and the participants. Together with optimal deferral percentages, this approach increases the probability that the plan’s participants will have a successful retirement.
Wendy Dominguez is president of Denver-based Innovest Portfolio Solutions.
With more than 20 years serving financial markets, John Sullivan is the former editor-in-chief of Investment Advisor magazine and retirement editor of ThinkAdvisor.com. Sullivan is also the former editor of Boomer Market Advisor and Bank Advisor magazines, and has a background in the insurance and investment industries in addition to his journalism roots.
