Benchmarking 'to' and 'through' target-date funds

How can well-meaning 401(k) plan executives prudently select and monitor target-date funds? A big part of the answer can be found by determining proactively whether a target-date fund's asset allocation and glidepath are consistent with a plan's particular needs. Target-date fund style benchmarks, a “to” index and a “through” index, can help throughout the process — from screening candidates to monitoring performance and asset allocation.

Plan executives should begin the selection process by developing an understanding of the behavioral tendencies and demographics of their employee population. They should articulate the investment implications of this analysis in their investment policy statement. For example, firms in high-paying industries might wish to select a target-date fund that is more sensitive to longevity risk than it is to market risk. The life expectancy of highly compensated employees might tend to be greater than average, so that aspect of the plan's demographics could support such an investment policy. Plan executives should also integrate implications of retirement plan design into their investment policy statement. For example, whether a defined benefit plan is offered will affect which target-date fund best fits a plan's needs.

With this perspective, executives can align the overall needs of their plan with a set of target-date fund candidates. If the results of their analysis call for heightened sensitivity to market risk, they could start the selection process by screening for funds that pursue a “to” style as indicated by consistency with a “to” benchmark index (see Exhibit 1). Conversely, if demographic and plan design factors point to more concern about longevity risk, they could start the selection process by screening for funds that pursue a “through” style as indicated by consistency with a “through” benchmark index. If neither style is strongly indicated, they could look at a set of target-date funds that are a blend of “to” and “through” — those that do not fall strictly into one or the other style.

In the monitoring phase, “to” and “through” target-date fund style indexes can be appropriate benchmarks for performance analysis and a source for comparing glidepaths (between the benchmark and any particular fund). They are superior to peer group analysis because genuine target-date fund style benchmarks are representative, investible, style-specific, known before each evaluation period and they permit performance attribution. Of course, these recommendations presume that appropriate target-date fund style benchmarks exist. S&P Indices is responding to that need by building its target-date index family. S&P Indices is developing consensus-driven “to” and “through” style indexes for every five-year target date from retirement income through 2055.

What are the elements of target-date fund style? The derisking policy of a target-date fund manager is certainly one. Whether the manager stops derisking at retirement or continues beyond seems to capture the idea of “to” and “through.” However, does derisking policy account for the entire picture? Implicit in the “to” style is heightened sensitivity to market risk, whereas the “through” style has more sensitive to longevity risk. This difference makes equity exposure around the retirement date and in the retirement income allocation another meaningful factor in determining target-date fund style.

As with all statistical exercises, the degree of uncertainty inherent in measuring participant demographics should be acknowledged. Target-date funds, including custom target-date strategies, are ideally aligned with the needs of a particular plan. However, individual participants retain all investment risk in defined contribution plans, so even a prudently selected target-date fund will have outliers in terms of its optimality for given individuals. Selecting a target-date fund for a particular plan is similar to fitting a line or curve to a set of data points. Because plan sponsors cannot fit a glidepath to each plan participant, they ought to think about the opportunity cost of choosing a custom target-date strategy. If plan demographics and behavioral tendencies justify paying for the creation of a custom strategy, it's appropriate to measure the custom strategy's opportunity cost relative to a representative benchmark. A consensus target-date style index is the most representative benchmark for such an opportunity cost analysis. Consensus target-date fund benchmarks measure the combined opinion of active target-date fund managers as to what asset class exposure is appropriate for each target date. They are representative, market-driven proxies for each target date that stakeholders can use to measure the success of any given target date strategy.

With respect to helping participants understand target-date funds, plan executives can provide appropriate benchmarks, financial education and clear communications to support proper usage of target-date funds — even for outlier employees. They can also illustrate how their plan's glidepath compares with that of a consensus target-date style benchmark. Lastly, they can communicate demographic assumptions in an engaging way so each employee can make an informed decision about which target date year within their plan's target-date fund glidepath best fits their individual retirement accumulation needs.

Philip Murphy is vice president at S&P Dow Jones Indices in New York, responsible for defined contribution channel management.