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August 06, 2015 | Retirement Plans
Target date fund (TDF) selection and monitoring is becoming more important as the assets held in these funds grow. Within the next decade, assets held by target date funds may surpass $1.5 trillion. In recognition of the challenges facing plan fiduciaries specific to evaluating TDFs, in February 2013 the Department of Labor (DOL) issued “Tips” which made clear that ensuring a Plan’s TDF is prudently selected should be at the top of plan fiduciaries’ “to do” lists. One tip that has attracted much industry attention is to “inquire about whether a custom or non-proprietary Target Date Fund (TDF) would be a better fit for your plan.”
Despite the industry discussion about custom TDFs, little guidance exists for fiduciaries who are responsible for TDF selection regarding specific factors that should be incorporated into the decision making process. Plan sponsors who want to improve participant outcomes can look to advisors to help distinguish industry chatter from real plan design solutions.
One reason often cited for using a custom TDF is the ability to access “best in class” managers, with the expectation that this approach will lead to a better overall performance experience. Even modest amounts of incremental returns from manager selection decisions over time can make a significant difference in plan participants’ retirement outcomes. But a single-minded focus on hiring “best in class” individual managers misses an important point: making the right manager selection decisions within each asset class is not as important as the asset allocation decisions themselves. The asset allocation decision is a primary investment determinant of how much wealth participants are able to accumulate during their working years and retain during retirement. Focusing exclusively on accessing “best in class” managers might lead a plan fiduciary to put excessive importance on short-term performance rather than long-term participant outcomes.
So when might a custom TDF make sense? The ability to tailor the glide path for a plan with unique needs is a compelling reason to pursue a custom TDF solution.
To understand if a custom glide path design may be warranted, plan fiduciaries should start by identifying what is unique about the plan’s demographics. When determining how different a plan may appear from various demographic perspectives, plan sponsors should focus on several key factors:
These factors may indicate that the plan participants might benefit from a glide path design not offered in the pre-packaged TDF marketplace.
It may not always be clear in what direction a demographic characteristic should influence the glide path design. For example, the presence of a defined benefit plan may suggest that participants are in a position to absorb larger portfolio losses without derailing their retirement savings progress, making a more growth-oriented glide path appropriate. Conversely, guaranteed retirement assets may alleviate the need for participants to take as much risk with their defined contribution assets. Plan fiduciaries should fully understand the rationale behind any custom glide path and TDF recommendation.
Plan fiduciaries should consider not only the influence of individual demographic characteristics, but also how they interact with each other. While a participant base may differ from the general population in one way, an alteration to the glide path may ultimately be inappropriate if the plan is also unique in another respect, potentially offsetting the need for action.
For example, an earlier than average retirement age translates to fewer years for participants to save and compound their savings, but also requires participants to accumulate larger portfolio balances in order to meet their spending needs over an increased number of years in retirement. If all other variables are left unchanged, higher investment returns (likely via increased equity exposure) would be necessary to accumulate the larger retirement portfolio balance required to meet participant retirement savings goals by the earlier retirement date.
However, if participants have exhibited strong savings rates and/or the employer has a generous matching contribution and history of profit sharing contributions, this may indicate the that overall contributions into the participants’ retirement portfolios are significant enough to offset some or potentially all of the need for increased equity exposure associated with the participants’ earlier retirement dates.
Potentially complicating matters even more are cases where unique characteristics are not consistent across the participant base. For example, the presence of a frozen defined benefit plan may result in longer-tenured employees receiving benefits while newer employers are not covered by the plan.
For plans with materially different demographic characteristics that indicate custom TDFs may be appropriate, the next step is to understand the different parties–such as custodians, record keepers, trustees, advisors/consultants, and asset managers—involved in the creation of custom TDFs. From there, fiduciaries may be in a better position to weigh the potential costs associated with a custom design against any potential benefits. Fiduciaries need to have a clear understanding of both the fees and “soft costs” associated with implementation, and the ongoing monitoring and oversight responsibilities they will have in comparison to a pre-packaged TDF solution.
Fiduciaries must move beyond industry chatter when addressing their participants’ outcomes. Armed with an understanding of a plan’s demographics, fiduciaries will be in a better position to determine how well a prospective TDF provider’s glide path assumptions align with their plan’s needs.
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