The title of a recent post by Schneider Downs, “New Trend in 401(k) Plans May Be a Headache for Fiduciaries” is a good description of what plan sponsors face as it relates to target-date funds.
There are many challenges involved in selecting, monitoring and deselecting TDFs:
• TDFs are focused on both primary portfolio management (i.e. individual security selection) as well as secondary portfolio management (i.e., asset allocation). This increases the complexity of fund evaluation compared to a single asset class manager (e.g., intermediate bond fund) who only has to focus on individual security selection.
• Evaluation of different glide paths adds increased complexity due to the fact that in essence, the manager of the glide path is in many respects attempting to forecast the future. A portfolio manager, who is charged solely with picking securities that are currently undervalued and then selling them at the point that they are deemed to be overvalued, does engage in some forecasting. A good example is the forecasting of interest rates, which a manager has to do when engaged in duration management. However, the TDF manager is going beyond this level of forecasting in deciding on the equity/bond allocation to maximize the outcomes as it relates time to retirement.
• While there are emerging TDF benchmarks, this is a relatively new science in investing. Therefore, these benchmarks (unless back-tested) do not cover a very long time period, and thus have limited exposure to the longer-term market cycles. Also, if back testing was the only issue, then all glide paths would look very similar and they do not.
• Perhaps the most difficult challenge and something that may account for the infrequency (relative to single asset class funds) of deselecting TDFs is the fact that all of the individual target-date funds are linked together through the glide path construct. This makes for an “all or nothing” situation, meaning that if a TDF provider is given the boot, then it is necessary to remove all of the TDFs in that provider’s suite of TDFs. This is due to the fact that the glide path is a common thread that runs from the earliest target date to the latest target date. There is also the practical challenge of communicating such a large change in investments to a broad section of DC investors as well as the potential consequences of making such a sweeping change. It is certainly very different from changing out a small-cap value manager.
What might these challenges tell us about the future of TDFs? There are several potential responses to these challenges:
• The ongoing effort to create credible benchmarks will continue. However, it is not very helpful to view each TDF as a standalone investment against another. The reality is that the plan sponsor is more concerned about which suite of TDFs to select given the impracticality of having anything other than a homogeneous lineup as it relates to the provider of the glide path.
• TDF models, which separate the glide path from the underlying fund types, may grow in popularity so as to simplify the evaluation of both the individual security selection and the asset allocation overlay. This allows for the tweaking of the underlying funds with the assistance of the plan advisor. It also allows for the core funds to be used in constructing the TDFs, thus simplifying the process.
• Plan sponsors may decide (as many are doing as it relates to individual asset class funds) to choose the passive route as it relates to choosing TDFs. The TDF indexing methodology could be documented in the Investment Policy Statement (IPS) and pass muster from a process standpoint. Essentially, the glide path would be the middle of the road of all glide paths and, thus, be based on the consensus or “wisdom of the crowd.” In this case, much as it is with other passive investments, it is simply a matter of choosing the right index. S&P Dow Jones Target Date Indices has created a set of TDF indices. Therefore, one could argue that there is a credible index/benchmark provider that exists today.
Regardless of these issues, the large TDF providers are not going to sit by and watch their business erode due to such challenges. As the annual Morningstar research report on TDFs illustrates, year after year, these proprietary TDFs have consistently outperformed the open architecture TDFs. A strong argument can be built that the approach taken by the large TDF providers has served DC investors well.
Additionally, rather than seeking to micromanage these highly qualified firms down to the minute detail, plan sponsors may look at the bigger picture relating to the process, philosophy and resources that these firms bring to the table as it pertains to the challenging task of providing a entire diversified portfolio to individual investors in five-year increments through a single suite of funds. Perhaps IPSs in the future will be designed in such as a way so as to view the selection of TDFs in a more global manner and the single TDF suite structure will continue to prevail as the dominate means of mass investing in DC plans for many years to come.
For plan advisors, one thing is certain: This discussion regarding the fiduciary challenges of TDFs will continue to unfold. They should stay attuned to how these challenges are being met by various plan sponsors and their investment providers.
