The February 2013 Department of Labor guidance on target-date fund screening and monitoring demonstrated an industry need for greater TDF transparency and more due diligence on the part of plan fiduciaries. Guidance explicitly called for a better understanding of overall portfolio construction and underlying investments along the glidepath. As fiduciaries, plan sponsors are also called on to evaluate whether their target-date funds are the right choices made in the best interest of their participants. Specifically, what about these choices will lead to plan success?
Many plan sponsors enlist a knowledgeable consultant as a trusted co-fiduciary. However, this arrangement does not completely offload the responsibility or liability to prudently select and monitor target-date funds and assess the value of their benefit in light of the cost. The DOL's urging for greater due diligence is a bellowing call to action for plan sponsors.
Since publication of these guidelines, we have seen marginal evidence of increased due diligence. Proprietary record-keeping solutions still make up more than 70% of target-date fund assets. Few proprietary record-keeping target-date funds can claim best-of-breed status. Historically, however, record keepers' TDFs had an overwhelming advantage in garnering the coveted qualified default investment alternative allocation. As consultants help their plan sponsors explore the target-date landscape, a migration toward better solutions is likely.
Advisers and consultants should be lauded for recent initiatives to refine their own target-date fund evaluation methods. Although still relatively new, this effort is an important step toward helping sponsors navigate a complex investment product. Furthermore, many investment policy statements establish processes for screening core asset classes but have not yet been expanded to accommodate the plan's QDIA, the most important investment on the menu. This, too, must change.
Beyond the regulatory guidance, a critical reason for target-date fund evaluation in today's market environment is the riskiness of the bond market. Diversification alone is not a good outcomes-based solution. Guided by their co-fiduciaries, plan sponsors must scrutinize the way their target-date fund provider manages asset allocation and navigates market risks. Given historically low U.S. Treasury yields and rich valuations among certain types of defensive equities such as dividend-paying stocks, there is a meaningful possibility that these investments will not provide the downside protection, volatility dampening or income-producing benefits for which they have traditionally been known.
With the DOL guidelines top of mind, many plan sponsors are becoming more paternalistic to help participants reach financial solvency in retirement. This goal is accomplished through a combination of auto features to augment participant contributions and finding a target-date fund provider experienced at active risk and asset allocation management. So what should a paternalistic plan sponsor do? Plan sponsors need to ask why the target-date fund asset allocation and portfolio positioning will work to meet the participant's retirement needs. As more plan sponsors feel the responsibility for preparing their participants for retirement, choosing an approach that employs dynamic asset allocation is a way to help them get there. This is especially true for TDF investors because a good portion of retirement funding happens close to and in retirement, which makes managing the risk of sustained capital loss vital.
Plan sponsors aren't expected to be investment experts themselves, although they should have a fair idea of what their TDF holds and the confidence to ask some simple but key questions. Through their consultant or adviser, they can explore why a specific asset allocation strategy and portfolio positioning is geared toward achieving participant goals and ultimately meeting their withdrawal needs.
These questions can help a plan sponsor deconstruct a provider's target-date fund approach.
A first question is about holdings: Is the target-date fund transparent? Although most providers disclose “holdings,” this usually refers to underlying funds or broad-based asset classes. The nature of a fund-of-fund construction does not show, with certainty, what a target-date fund actually holds or why. Plan fiduciaries may request the total number of underlying holdings for target-date funds, alongside the distinct number of holdings. The latter point recognizes that target-date funds using a fund-of-funds approach might hold the same security in more than one underlying fund.
Second question: Do all levels of portfolio management coordinate? Lack of coordination is often illustrated by examining coordination among the target-date series' underlying mutual funds. Target-date vehicles have on average 15 underlying mutual funds. Securities overlap happens because funds with different investment objectives might invest in the same securities. Moreover, a value manager might buy one stock, while a growth manager is selling it, resulting in uncoordinated portfolio positioning decisions accompanied by transaction fees.
Third question: Is the target-date fund overdiversified? Clear signs of overdiversification include owning too many mutual funds within an investment category or an excessive number of individual stock positions, which might result in index-like returns. It is neither reasonable nor prudent for a plan fiduciary to pay active fees for index-like results. Therefore, plan sponsors and their consultants should consider the “active share” measure of the most equity-oriented target-date vintage to identify if the style of active management truly intends to navigate different market risks.
Achieving greater due diligence and establishing a rigorous process for TDF evaluation is best done with the assistance of an investment consultant. However, plan sponsors need not be overwhelmed by the process. Asking simple but direct questions of your target-date provider might shine additional light on the effectiveness of their product.
The DOL has challenged plan fiduciaries to better understand and reasonably assess whether a target-date fund is truly appropriate for meeting their plan objectives. Challenges presented by the current market environment might be better met with a dynamic asset allocation approach. This is especially true for those fiduciaries seeking a best-of-breed QDIA solution. Asking pointed, key questions and working with consultants and advisers who can identify experienced managers focused on navigating inevitable investment risks enables plan sponsors to pursue a better path toward meeting long-term objectives for participants. The time to act is now.
Mary Moglia-Cannon is a senior analyst with the investment review group and a portfolio strategist with the portfolio strategies group at Manning & Napier Advisors LLC.