Meeting DOL Guidelines, Article 2 of 5
Satisfy DOL guidelines with a participant-focused approach to evaluating target date funds.
Wesley Phoa, portfolio manager, target date and fixed-income funds, 21 years of experience.
Jason Bortz, ERISA attorney, 17 years of experience.
Toni Brown, CFA senior defined contribution specialist, 25 years of experience.
John Doyle, senior defined contribution specialist, 28 years of experience.
Rich Lang, investment specialist, 21 years of experience.
Target date funds have enormous potential to make defined contribution plans more effective and straightforward for participants. But to capture the funds’ benefits — and to help meet fiduciary obligations — plan sponsors must implement thorough, well-documented evaluation procedures.
The U.S. Department of Labor has made it clear that plan sponsors must carefully evaluate target date series before adding them to a plan’s investment lineup, periodically re-evaluate any target date funds currently offered by the plan and document the process.1 Yet evaluating and understanding target date funds can present challenges to plan sponsors. Although the funds are designed to make retirement investing simple and convenient for plan participants, their underlying construction can be complex and can vary widely among the dozens of series on the market.
We believe that plan sponsors’ evaluation process should encompass the following five considerations:
Glide Path Construction
Cost Versus Value
Quality of Underlying Funds
Consistency and Repeatability
In this series of five articles, we walk plan sponsors, consultants and retirement plan advisors through each of the five components of the evaluation process. Thorough, effective target date fund evaluation will help plan sponsors fulfill not only the letter of the fiduciary rules, but also their intent: to give participants the best opportunity to meet their retirement saving and investing needs.
Consideration 2: Glide Path Construction
The glide path is the heart of a target date series. The asset allocation dictated by the glide path has the greatest influence on participants’ success managing longevity and market risk. When evaluating glide path construction, plan sponsors should consider several factors, including:
A glide path should provide a large enough stock allocation to protect against longevity risk, without exposing participants to excessive market risk. Providers have differing perspectives on what stock allocation best meets these goals, however, and the various series on the market provide a wide range of stock exposures (see the “Range of Target Date Universe Stock Exposure” chart below).
Note that stock allocation is not a perfect proxy for exposure to market risk. Some providers may be able to maintain relatively high stock allocations while reducing market risk by adjusting their mix of stock assets. (For more on this topic, see the “Allocations Within Asset Classes” section below.)
Some but not all of the disparity in stock allocations among target date series reflects the difference between those that invest “to” retirement versus “through” retirement.
Plan sponsors tend to focus intently on “to” versus “through.” We believe that “through” retirement series are more appropriate for most participants.
“To” strategies typically bring equity exposures to low levels at retirement, based on the idea that participants will roll assets into an individual retirement account. A rollover is nothing more than a transfer. It does not change the objective for which the savings are invested: to provide the participant with the optimal chance to fund retirement. Allocations should meet participants’ needs over their actual time horizon, as “through” series are designed to do, regardless of the date the transfer occurs.
Inclusion of Nontraditional Investments
Providers have very different philosophies about the value of including nontraditional investments such as commodities, real estate, private equity and absolute-return vehicles. These options might offer benefits such as diversification and inflation protection, but they also have downsides, including illiquidity and high fees.
Allocations Within Asset Classes
Providers also take different approaches to target date funds’ exposures within the major asset classes.
At the most basic level, providers differ about which subsectors to include within the major asset classes of stock and fixed income. Some providers favor large-cap domestic stocks; others hold relatively large stakes in small-cap stocks and international stocks. Some focus on growth-oriented stocks, others on more stable, dividend-paying stocks. Fixed-income allocations may focus almost exclusively on investment-grade U.S. securities, or expand into lower rated assets such as high-yield bonds, leveraged loans and emerging markets corporate debt. Plan sponsors should understand providers’ rationales for including specific types of securities.
Just as important, providers differ on whether to adjust suballocations within asset classes over time. They take one of two approaches:
Static. Some providers leave suballocations unchanged throughout the glide path. For example, a series’ equity allocation might have
60% / 20% / 20% allocations to U.S. large-cap stocks, U.S. small- and mid-cap stocks, and international stocks, respectively — whether the fund is designed for participants retiring in 2015 or 2055.
Evolving. Other providers tailor their suballocations at each point in the glide path. We believe that this is more effective than a static approach.
- Evolving stock allocations. A target date series’ stock allocation might gradually shift from an emphasis on higher volatility, growth-oriented stocks to an emphasis on lower volatility during the course of the glide path.
- Evolving fixed-income allocations. The series might start the glide path emphasizing intermediate- and long-duration government securities, to provide the stock-heavy portfolio with a hedge against bear markets. As the participant approaches and enters retirement, and the equity allocation falls, the fund might shift to a more diversified bond portfolio that includes high-yield bonds, Treasury Inflation-Protected Securities and high-quality short-term securities.
Active Versus Passive Management
Plan sponsors do not need to make an either-or decision about active versus passive management. All but five of the 43 largest target date series in 2013 managed at least 10% of their assets actively.2
That said, passive management seems to have gained some momentum in the marketplace. Indexers commonly note that the average active manager lags the benchmarks. However, not all active managers are average. Capital Group research has demonstrated that certain active managers have consistently produced better results than their benchmarks. A target date series that uses only passive management may miss opportunities to manage market risk by investing based on individual securities’ risk characteristics. Additionally, certain fund objectives are not achievable using passive strategies, such as investing for equity income.
Retirement Efficiency Ratio
The Retirement Efficiency Ratio (RER), a metric developed by Capital Group, can help plan sponsors determine the efficiency with which a glide path balances longevity and market risk. This ratio measures a target date fund’s equity exposure (to indicate its ability to address longevity risk) per unit of volatility (to measure its exposure to market risk) at a given point on the glide path. The higher the figure, the more efficiently the fund has balanced those risks.
Retirement Efficiency Ratio
Ideas for Action
- Examine the size of stock allocations throughout the glide path
- Search for a series whose investments in traditional asset classes provide high diversification without sacrificing liquidity or increasing fees
- Seek low-fee, active options that can provide opportunities beyond benchmarks
- Look for a series that takes an evolving approach to allocations within major asset classes to help lower volatility
- Assess how well a series balances equity exposure and risk by identifying a series with a high Retirement Efficiency Ratio