As the defined contribution industry continues to mature, plan fiduciaries have become more familiar with how target-date funds can be used as an effective qualified default investment alternative.
However, given the complexities associated with target-date funds' many moving parts, the growing number of distinct approaches and the need to look beyond the record keeper's proprietary offering, choosing the right suite of TDFs can be a daunting responsibility.
Recognizing the unique challenges facing plan fiduciaries, the Department of Labor in February 2013 issued tips to assist plan fiduciaries with this increasingly important decision. The DOL provided well-rounded guidance and made significant strides to improve plan fiduciaries' understanding of TDFs, as well as an opportunity to improve upon current retirement industry standards.
In some respects, the DOL's guidance might have simply served as a reminder for plan fiduciaries to continue with many of the best practices currently used when selecting and monitoring TDFs. For example, the DOL suggested plan fiduciaries “make sure (they) understand the fund's glidepath, including when the fund will reach its most conservative allocation and whether that will occur at or after the target date.” The latter part of this suggestion — the consideration of whether a TDF's glidepath should be managed “to” or “through” retirement — has generated a lively debate in the industry.
In fact, it appears that the “to” vs. “through” distinction has been used as a key criterion by many plan decision-makers to help distinguish and potentially choose among the wide range of glidepaths. While this is an element of TDF evaluation, we anticipate the “to” vs. “through” distinction will play a reduced role going forward, as plan fiduciaries' TDF due diligence programs continue to evolve, and a greater emphasis is placed on better understanding of the risk management techniques managers have in place to navigate an ever-changing market environment.
When plan fiduciaries evaluate “to” vs. “through” approaches, what are the risk management trade-offs that should be considered? The risk with the most perceived immediacy is the potential for a drawdown in a participant's assets during retirement to affect their ability to meet ongoing living expenses. In contrast, a risk that is very real, but not as apparent over the shorter term, is failing to grow assets adequately during retirement years.
Withdrawals from a portfolio can turn volatility into a risk of a sustained loss of capital (“capital risk”) as assets withdrawn from a portfolio to meet spending needs are not able to rebound with an improvement in the markets. On the other hand, increases in life expectancy require continued portfolio growth during retirement in order for participants to generate larger retirement balances than they might have initially planned or risk outliving available assets (“longevity risk”).
In general, “to” glidepaths are considered to be more conservatively positioned near the target date relative to “through” glidepaths to help protect against capital risk over longevity risk. We would argue this relationship does not always hold true, as there is little consistency in the allocation to stocks and other long-term investments once the landing point is reached. As such, “to” and “through” glidepath approaches should not be blindly categorized as conservative and aggressive. Furthermore, if the ultimate goal of a plan fiduciary is to gain a better sense of a glidepath's overall risk/reward profile, additional characteristics should be included to conduct a well-rounded assessment. For example, this may include the glidepath's broad asset class composition at key stages leading up to and after the target date, the potential evolution in subasset class exposure as participants' investment objectives change, and the steepness of the glidepath as the target date approaches.
Our assessment of the TDF landscape indicates that a greater number of providers have constructed a “through” glidepath design to help protect against longevity risk. The preference for a “through” approach is consistent with our view that unless a plan sponsor designs a plan with the requirement that participants exit the plan at retirement, there is the possibility that a meaningful percentage of the participants could continue to leave their assets in the plan during retirement. For participants that do remain in the plan post-retirement, a conservative “to” glidepath design might fail to provide the level of growth necessary to allow today's relatively modest retirement account balances to support living expenses over a 20- to 30-year retirement timeframe.
Conversely, if a significant percentage of participants take lump-sum distributions at retirement, a greater focus on limiting capital losses might be more prudent to prepare for potential liquidation of their accounts, and consistent with how most “to” glidepaths are positioned.
To make an informed decision, plan fiduciaries should consider whether participants taking lump-sum distributions at retirement are likely to spend those assets over a relatively short time period. This provides an indication of whether volatility or market risk should be a primary concern. Alternatively, if participants generally reinvest their retirement assets in the markets for a substantial period (e.g., potentially in a rollover IRA) a “to” glidepath design leading up to the target date may turn out to be counter-productive if it doesn't accurately represent their intended investment time horizon.
In addition to understanding participants' behavior at or near their expected retirement date, the selection of an appropriate glidepath is largely dependent on the magnitude of participants' spending needs. There is clearly a need to become increasingly concerned about capital losses as participants' withdrawal rates become meaningful and potentially unsustainable. The combination of a severe market downturn (particularly early on in retirement) and a resulting increase in withdrawal rates can lead to a premature exhaustion of retirement assets. As such, plan fiduciaries should carefully consider at what point along the glidepath their participants begin drawing down retirement assets at a rate that indicates a need to focus on protecting wealth accumulation. This should dictate to what extent their expectations align with a provider's glidepath assumptions and design rationale.
We believe that the potential for significant capital losses is a key risk to guard against as the target date approaches. Equally important, the risks and opportunities presented by the prevailing market environment should determine the specific allocation at any stage of the glidepath. History has shown that there are times when the margin of safety provided by certain equities presents an opportunity to pursue a more growth-oriented positioning — comparable to many of the “through” glidepaths found throughout the industry today. In contrast, there will be times when the potential for capital losses warrants a more conservative posture than was originally anticipated, and that may be more in line with a conservative “to” glidepath approach.
The DOL's TDF guidance has helped to shift plan fiduciaries' focus away from traditional investment evaluation criteria, such as short-term risk and return measures. Greater emphasis is being placed on ensuring the glidepath and investment features of a TDF suite aligns with plan goals, participant demographics and overall needs. The “to” vs. “through” distinction is just one of the many informative characteristics to consider when comparing and contrasting TDFs. As TDF due diligence continues to evolve, one of the most impactful ways plan fiduciaries can help participants achieve positive outcomes is to examine the role of prevailing market conditions in a provider's glidepath construction. Market conditions will inevitably change as participants' strive to achieve their long-term retirement goals. Plan fiduciaries would be well-served to focus TDF assessment efforts on better understanding what mechanism, if any, their target-date provider uses to manage the risks that are most prevalent.
Jeff Coons is president of Manning & Napier and Shawn Sanderson is a senior investment consultant with Manning & Napier.
