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Introduction

The provisions of the Pension Protection Act (PPA) of 2006 defined target date funds as one of three types of qualified default investment alternatives (QDIA) for use in qualified retirement plans. While the final regulations require plan fiduciaries to meet several technical and operational requirements to qualify for safe harbor protection, the following discusses the utilization of the Manning & Napier target date options as QDIAs, and provides guidelines for translating individual participant birthdates into a Manning & Napier target date option when target date funds are being utilized as the default investment.

QDIAs as Defined by the Department of Labor (DOL)

The DOL chose to define QDIAs in terms of mechanisms for investing participant monies, rather than as specific products. The final regulations provide for four types of QDIAs (with the last option serving only as a temporary solution). The four types of QDIAs include:

1. A product with a mix of investments that takes into account the individual’s age or retirement date (an example of such a product could be a lifecycle, targeted-retirement-date fund, or age-based fund);
2. A product with a mix of investments that takes into account the characteristics of the group of employees as a whole, rather than each individual (an example of such a product could be a balanced fund or a risk-based option);
3. An investment service that allocates contributions among existing plan options to provide an asset mix that takes into account the individual’s age or retirement date (an example of such a service could be a professionally managed account); and
4. A capital preservation product for only the first 120 days of participation (an option for plan sponsors wishing to simplify administration if workers opt-out of participation before incurring an additional tax).

It is worth noting that the DOL’s position in the adopting release of the final regulations is that any of the four types of QDIAs are appropriate and “….the rule does not require a plan fiduciary to undertake an evaluation as to which of the qualified default investment alternatives provided for in the regulation is the most prudent for a participant or the plan.” The DOL generally requires a QDIA to include a mix of stocks and bonds that recognizes the trade-off between capital appreciation and capital preservation.

Selecting a Target Date QDIA

The 2006 regulations clearly state that, when slecting a QDIA, “The selection of a particular qualified default investment alternative (i.e., a specific product, portfolio or service) is a fiduciary act and, therefore, ERISA obligates fiduciaries to act prudently and solely in the interest of the plan’s participants and beneficiaries. A fiduciary must engage in and document an objective, thorough, and analytical process that involves consideration of the quality of competing providers and investment products, as appropriate.”

In February 2013, the DOL’s Employee Benefits Security Administration (EBSA) – the federal agency responsible for issuing guidance regarding ERISA’s fiduciary requirements – issued guidance regarding the selection of target date funds by plan fiduciaries. The guidance entitled “Target Date Retirement Funds – Tips for ERISA Plan Fiduciaries” is available on the DOL’s website at: http://www.dol.gov/ebsa/pdf/fsTDF.pdf. While the guidance provides a general framework of best practices for selecting investments for a 401(k) plan, it specifically addresses the selection and monitoring of target date funds (TDFs). In the discussion on establishing a process for comparing and selecting TDFs, it recommends that plan sponsors “consider how well the TDF’s characteristics align with eligible employees’ ages and retirement dates.” In addition to age, it may be useful for plan fiduciaries to also consider the existence of other retirement assets (such as defined benefit plans), salary levels, employee turnover rates, contribution rates, and withdrawal patterns.

Furthermore, the due diligence process for selecting a target date QDIA is generally more complex than the due diligence process for a single asset class option and should focus on understanding plan goals and demographics. As such, the plan sponsor should consider glide path suitability, as well as the attributes of the target date family, to select a family that is aligned with a plan’s specific needs.

To determine glide path suitability, plan sponsors should not only consider participants’ risk tolerance, but also their capacity for risk (i.e., the magnitude of loss that participants may be able to withstand). Generally speaking, a higher risk capacity may allow for a more aggressive glide path, while a lower risk capacity may indicate the need for a more conservative one. For key factors that influence risk capacity, please see Chart 1 on the following page.

After determining participants’ risk capacity, plan sponsors are tasked with evaluating the attributes of various target date families to ensure that they align with participants’ needs. One of the most popular ways in the industry to categorize glide paths is by labeling them either “to” or “through”. Glide paths that reach their landing point at the target date are labeled “to” glide paths, while ones that continue adjusting equity exposure after the target date are labeled “through” glide paths. While it does not always hold true, generally speaking, because “to” glide paths tend to be more conservatively positioned near the target date relative to “through” glide paths, they are often categorized as conservative. However, it is important to be aware that the relationship can change in the years following the target date. Specifically, because “through” glide paths continue to de-risk after the target date, they may ultimately be more conservatively positioned when compared to “to” glide paths during the later stages of the roll down. As a result, “to” and “through” glide path labels should not be viewed as indicative of conservative or aggressive approaches. Instead, plan sponsors should consider a variety of factors to determine where on the risk/reward spectrum a glide path falls:

• Equity exposure along the glide path, particularly, near the target date
1. Additional emphasis should be placed on the equity exposure near the target date/at the target date due to the fact that it is often participants’ most vulnerable point. At this stage of participants’ careers, retirement assets are generally at their peak, and as time horizons shorten, the focus shifts from contributions to investment returns, in combination with withdrawal rates, to drive retirement outcomes.

• Steepness of the glide path leading up to retirement
1. It’s important to consider the potential risks associated with a steep glide path. A steep glide path typically maintains a growth-oriented position until close to retirement. At that point, it reduces exposure to growth-oriented securities in a relatively short period of time. This type of approach may magnify timing risk. Specifically, there is a heightened risk of “locking in” losses during meaningful declines as a glide path’s exposure is systematically reduced, thus, potentially limiting a TDF’s ability to adequately participate during the market’s subsequent upturn.

In addition to the specific glide path considerations, due diligence should be conducted on standard fund selection criteria, such as stability of management, reasonableness of fees, etc. Plan sponsors should also consider the following when reviewing the investment process employed by the target date family:

• Does the investment process take into consideration the prevailing market environment (i.e., utilizing an active approach to asset allocation and risk management)?
• Is the target date family managed by a team that has a long-term track record of proven performance results over a variety of market environments?
• Is there a mechanism in place to facilitate coordination among all professionals involved in the investment decision-making process, for both the target date options as well as the underlying funds?
• Are the portfolio’s underlying securities effectively, but not overly, diversified?
• Are securities selected based on an investment strategy that recognizes the impact current valuations and prices have on future returns?

Given the important role that asset allocation plays in portfolio returns, and the DOL’s emphasis on capital accumulation and capital preservation through a mix of stocks and bonds, a target date manager’s approach to portfolio diversification is a key factor to consider when evaluating and identifying a prudent QDIA. Since target date options are designed to be an all-in-one investment solution for participants, they generally provide broad diversification across multiple asset classes. However, there is no “set it and forget it” solution that effectively protects participants from all potential risks. Not only can the attractiveness of an asset class change along with market conditions, but so, too, can the diversification benefits to the overall option.

Plan fiduciaries should understand the benefit(s) each underlying investment strategy is expected to contribute to the overall target date option in light of the prevailing market environment (e.g., risk mitigation, return enhancement, correlation reduction). In addition, the benefit of increasing diversification tends to diminish after a certain point. If there is no coordination among all portfolio managers involved in the decision-making process, the various securities independently selected by the numerous underlying managers may end up reflecting the broad markets in aggregate, and there may be little room for the target date option to add value versus the broad market from a security selection perspective.

Manning & Napier Retirement Target Options as QDIAs

To be consistent with the DOL regulations, TDFs must incorporate a glide path schedule that fully takes into consideration an investor’s changing investment objectives over time. As such, Manning & Napier’s target date strategies qualify as QDIAs under the first investment alternative outlined on page 2 of this paper. The Manning & Napier target date options are offered through four share classes of collective investment trust funds and three share classes of mutual funds.

The glide path ranges of Manning & Napier’s TDFs (depicted in the chart below) reflect recognition of the unique goals related to three key phases during a participant’s working life (i.e., Early Career, Mid Career, Near Retirement), as well as In Retirement, in light of the inherent investment trade-off between capital preservation and capital appreciation.

Manning & Napier employs a Glide Range that not only transitions toward a more conservative allocation as the target date nears, but also offers the flexibility to actively adjust the asset allocation within a broad range based on prevailing market and economic conditions. A key goal of target date options is to allow participants to delegate what is widely considered the most important investment decision (i.e., translating investment objectives to a specific asset allocation) to an investment professional. Therefore, TDFs must incorporate a glide path schedule that fully takes into consideration a participant’s changing investment objectives over time.

In addition to allocating assets among securities based on the length of time until the fund’s target date, Manning & Napier’s target date strategies provide a greater degree of risk management by proactively adjusting equity allocations within the glide path range based on prevailing market and economic conditions.

Deciding to Default Based on Individual Ages

Each individual participant can be defaulted into an appropriate target date investment option based on their age. As target date QDIAs must be structured to become progressively more conservative as the target year approaches (i.e., follow a “glide path”), using such a default option allows participants to stay appropriately invested in a single option throughout their investment lifetime. However, plan fiduciaries should review the provider’s glide path to determine how the target date family adjusts the asset mix as the target date approaches.

The personalized focus of this strategy requires that birth date information for each participant is readily available and will result in the plan having multiple default options (i.e., a coordinated family of TDFs) that meet the varying expected retirement dates of all participants. This strategy may be preferred by companies that have a diverse participant population in terms of age, or those that experience a lower degree of employee turnover.

TDFs may be an appropriate default option when:

• age information is readily available for all participants
• plan sponsors believe that participants with similar ages and/or target retirement dates have similar investment objectives and risk tolerance
• plan sponsors want to provide participants with one option that can be used throughout their investment lifetime
• there is a large dispersion between participant ages

Implementing a Target Date QDIA

The DOL’s final regulations governing QDIAs require plan fiduciaries to meet several technical and operational requirements to qualify for safe harbor protection (e.g., notice requirements). In addition, when target date options are used as a default solution, it is important to clearly define the default decision rules that will determine which target date option each defaulted participant will be invested in. These decision rules must be supported by the plan’s recordkeeping service provider (i.e., the plan’s record keeper must have birth dates for all participants and have the ability to track and invest defaulted participant assets according to the decision rules), and should be clearly communicated to participants.

Decision Rule 1:

Selecting an Assumed Retirement Age

In order to translate retirement date ranges into a default decision, it is necessary for the plan sponsor to choose an assumed retirement age (i.e., target retirement date). This could be a standard retirement age such as 65, a normal retirement date as defined in the plan document, or another age that the plan sponsor and their plan advisors feel is an appropriate retirement age for their participants.

Decision Rule 2:

Determining the Anticipated Retirement Date Ranges

Since target date funds are typically available in five-year increments, the second decision rule must determine the TDF breakpoints. A mid-point approach provides a simple and straightforward mechanism for defaulting participants into TDFs. This approach defaults participants into the TDF that is closest to the year they expect to retire. For example, if a participant’s anticipated retirement date is in the year 2023, default that participant into the Target 2025 Fund.

We believe the appropriate default breakpoints for target date QDIAs that are set up in five-year increments are illustrated in the table below.

Applying the Default Decision Rules

Once the default decision rules have been finalized, the plan’s recordkeeper can use these rules to properly default plan participants into the appropriate TDF based on the available birth date information. To illustrate how these default decision rules can be applied, we have included sample default scenarios based on various assumed retirement ages in the Appendix.

Conclusion

We believe that Manning & Napier’s target date portfolios satisfy the requirement for a QDIA under the DOL’s final regulations and would be appropriate for plans seeking an age-based approach under the first QDIA investment alternative.

We also believe using breakpoints as discussed to default participants into a target date option is an appropriate mechanism for defaulting participants when using a target date fund as a QDIA.

It is our opinion that participants defaulted to target date funds are generally more likely to recognize the importance of risk management, placing a higher priority on capital preservation (i.e., protection during difficult market conditions) in pursuit of their long-term investment objectives. Manning & Napier’s focus on managing against downside risk and avoiding permanent loss of capital is not only consistent with the DOL regulations, but can also help keep defaulted participants on track for retirement. We believe that Manning & Napier, with over 40 years of proven experience managing life cycle strategies, is uniquely positioned to help plan sponsors provide their participants with a prudent QDIA solution and to help participants stay on track for successful retirement outcomes.

Manning & Napier’s life cycle offerings include target date (age-based) and lifestyle (risk-based) mutual funds (Manning & Napier Fund, Inc. Target Series and Pro-Blend^® Series) and affiliate collective investment trust (CIT) funds (Manning & Napier Retirement Target CIT Funds, MANNING & NAPIER GOAL^® CIT Funds, and Manning & Napier Pro-Mix^® CIT Funds).

Because target date funds invest in both stocks and bonds, the value of your investment will fluctuate in response to stock market movements and changes in interest rates. Investing in target date funds will also involve a number of other risks, including issuer-specific risk, foreign investment risk, and small-cap/mid-cap risk as the underlying investments change over time. Investments in options and futures, like all derivatives, can be highly volatile and involve risks in addition to the risks of the underlying instrument on which the derivative is based, such as counterparty, correlation and liquidity risk. Also, the use of leverage increases exposure to the market and may magnify potential losses. Additionally, some target date funds invest in other funds and therefore, may have additional risks associated with the underlying funds. Principal value is not guaranteed at any time, including at the target date (the approximate year when an investor plans to stop contributions and start periodic withdrawals).

For more information about any of the Manning & Napier Fund, Inc. Series, you may obtain a prospectus at www.manningnapier.com or by calling (800) 466-3863. Before investing, carefully consider the objectives, risks, charges and expenses of the investment and read the prospectus carefully as it contains this and other information about the investment company.

Manning & Napier Advisors, LLC (Manning & Napier) provides investment advisory services to Exeter Trust Company (ETC), Trustee of the Manning & Napier Collective Investment Trust funds. The Collectives are available only for use within certain qualified employee benefit plans. The Manning & Napier Fund, Inc. is managed by Manning & Napier. Manning & Napier Investor Services, Inc., an affiliate of Manning & Napier and ETC, is the distributor of the Fund shares.