DC plans move to custom target-date portfolios

Participant needs are key to move toward custom target-date funds

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Shifting: Carol Cypert thought the custom approach would redirect the participant focus ‘from how to invest to how to save.'

The $2 billion City and County of San Francisco Deferred Compensation Plan introduced target-date investing to participants on April 27, the latest example of a large DC plan choosing a customized approach.

Following two years of study, plan executives decided custom target-date funds would better serve participants than off-the-shelf funds. Plus, “we could factor in any unique workforce demographics,” said Carol Cypert, deferred compensation manager. “We want participants to redirect their focus from how to invest to how to save.”

A custom portfolio also offered more flexibility in choosing and terminating managers and adjusting investment options, she said. Eighteen funds from 12 money managers are used. “The main issue was diversification,” Ms. Cypert said.

Russell Investments advised the San Francisco plan on creating the custom portfolio and developing the glidepath.

As target-date funds take up a bigger piece of DC plan assets — thanks in part to their qualified default investment alternative status — custom funds are expected to play a more prominent role, research by Casey, Quirk & Associates LLC, Darien, Conn., shows.

The firm forecast that target-date funds will account for $3.68 trillion, or 48%, of the predicted $7.7 trillion in DC assets by 2020. Of that $3.68 trillion, about 37% will be in customized portfolios.

Target-date funds represented $550 billion, or 12.5%, of the $4.4 trillion in DC assets in 2010. Customized strategies totaled about 26% of the target-date assets.

Various surveys confirm that custom target-date portfolios are gaining acceptance, albeit slowly. For defined contribution plans that had target-date fund options in 2010, 8.1% offered customized portfolios, compared with 7.6% in 2009, according to the most recent surveys by the Plan Sponsor Council of America, Chicago.

Among the largest plans — those with more than 5,000 employees — custom strategies represented 16% of the PSCA target-date universe in 2010 vs. 14% in 2009.

Also, surveys from Aon Hewitt, Lincolnshire, Ill., show that 19% of DC plans with more than $200 million offering target-date funds had customized versions in 2011, compared to 14% in 2009.

And in its annual surveys of DC plans, Callan Associates Inc., San Francisco, found 13.2% expect to offer custom target-date portfolios this year. Last year, 11.3% of plans offered them.

Morningstar Inc. estimates that half the 30 companies in the Dow Jones industrial average offer custom target-date funds, said Jeremy Stempien, director of investments for the retirement solutions business of the Chicago research firm. When Morningstar designs custom target-date funds, it takes into account, among other factors, employee demographics, the presence or absence of a DB plan, participants' savings rates, the size of account balances, and trends among employees to remain in or leave the DC plan when they retire, Mr. Stempien said.

The San Francisco deferred compensation plan chose a custom target-date portfolio for many of the same reasons that other DC plans select off-the-shelf products. It helps participants who lack the time to manage their investments or who “are overwhelmed by the many investment choices available in the core investment lineup,” Ms. Cypert said. It also helps those “who do not have the financial literacy to invest through the self-directed brokerage option.”

5-year increments

The funds are offered in five-year increments for a participant's expected retirement date. There's also a target-date fund for retirees who no longer contribute.

Previously, the plan had three risk-based funds with combined assets of $400 million. Participants investing in these funds are being mapped into the target-date series, and the risk-based funds have been dropped, Ms. Cypert said.

One of the biggest companies to go the custom route is United Technologies Corp., Hartford, Conn., which offers the option in its $13.8 billion 401(k) plan for salaried employees and $2 billion plan for union workers.

UTC first offered a target-date option in January 2006, using off-the-shelf funds from Vanguard Group.

UTC executives had considered initially installing a custom target-date series. “We concluded that our rollout might be even more successful through the addition of a competitively priced, off-the-shelf solution from a well-known mutual fund provider,” Robin Diamonte, chief investment officer, said in an e-mail. “In that way, we could leverage the brand recognition of the fund provider to attract the attention of our participants.”

UTC was pleased with the target-date option, adopting it as a QDIA in January 2008, she added. Target-date funds now represent $926 million in the salaried employees' plan and $110 million in the union workers' plan.

UTC's shift to a custom target-date fund design in January 2011 “was part of our effort to redesign our plan options in a way that would make them easier to understand” as well as provide lower costs and greater flexibility for participants, Ms. Diamonte wrote. The funds are managed by AllianceBernstein (AB) LP (AB), New York.

Starting June 1, a separate “lifetime income strategy” option will offer an insured minimum withdrawal benefit.

This option “builds them their "own' portfolio, which holds investments and establishes secure income benefits the participant can see,” Ms. Diamonte said. “So it's much simpler to decide if they are ready to retire.”

The glidepaths for the target-date funds and the lifetime income option are similar until about age 45. “The big difference is that Lifetime Income Strategy holds a split of 60% equity and 40% bonds static after the age of 60.” The target-date funds “continue to reduce equity through the age of 80.”

The $712 million 403(b) plan of the Adventist Retirement Plans, Silver Spring, Md., tried off-the-shelf target-date products twice before switching to a custom version April 25.

Employee demographics was one reason for switching to a custom approach, said Delbert Johnson, administrator of the plan that serves members of the Seventh-Day Adventist Church in the U.S. The target-date portfolio accounts for 41%, of 403(b) plan assets.

The church plan used an off-the-shelf product from Trajectory Asset Management in 2006, then replaced it with another traditional target-date product from Ibbotson Associates Inc., a subsidiary of Morningstar, in 2010. The custom plan was thendeveloped by Ibbotson.

“We determined that we could do better with a more customized approach because of our aging employee base,” Mr. Johnson said. “We felt we could treat (our investments) with a little more precision.”

A customized glidepath also takes into account the different sources of retirement income among participants, such as Social Security and a DB plan that was closed to new employees at year-end 1999, Mr. Johnson said.