Sponsored Content

Diversification in target-date funds is more important than you think

Toni Brown
Senior Retirement Strategist

Capital Group, home of American Funds

One investment topic that rarely, if ever, goes out of style is diversification. But it’s not often discussed in the context of target-date funds, and that’s a problem. Diversification should play a central role when defined contribution plan sponsors seek to bolster their retirement programs.

“It’s important to have diversification, but plan sponsors have to understand what that diversification provides or doesn’t provide,” said Toni Brown, senior retirement strategist at Capital Group, home of American Funds. “At some point, additional diversification doesn’t necessarily add value. What does add value is diversification that can protect on the downside, especially for participants who are near retirement and moving into retirement. Not all diversification does that.”

Diversification that provides some downside protection depends on the mix of stocks and bonds in a target-date fund series and how that allocation changes as participants move closer to — and then into — retirement. In other words, the glidepath.

“If we think about glidepaths at a high level, it’s really the stock/bond mix that drives a significant amount of the growth, as well as the downside protection,” Brown said. “What matters is how that glidepath has been implemented — whether it’s through passive management or active management — and what types of sub-asset classes are used to fill in for the stocks and bonds; but also what plan sponsors use to add further protection around retirement and how they manage the portfolio in retirement when people are actually taking money out.”

Major target-date providers that traditionally had lower equity allocations in their target-date series have been increasing that allocation across the glidepath, a move that has benefitted participants as the equity market has done well over the last several years. But at this point, most glidepath changes, according to Brown, have been tweaks around the edges, not wholesale changes.

“What’s been done has been very solid and everyone’s put a lot of work and time and thought into it,” she said.
Brown said one issue that plan sponsors need to understand is the composition of the equity and bond allocations, not just the asset allocation. The components that make up those allocations can play a major role in how the funds perform and determine which funds are right for which participants. And that brings the focus back to diversification.

“Diversification is great, but in market downturns, correlation tends to go to one. We all found that out painfully in 2008,” she said. “Since diversification cannot fully protect you, you need to understand how the underlying assets are managed and if they’re managed in such a way that can provide protection without solely relying on diversification.”

At Capital Group, as the firm’s target-date series get closer to and into the retirement date, the equity component of the portfolios switches to historically less-volatile equity securities, which is designed to provide additional flexibility to the bond component.

“It’s more value-oriented, focused on stocks that pay dividends and grow dividends,” Brown said. “The reason for that is to seek lower volatility. If you can have lower volatility in your stock portfolio but still have growth, that impacts how you can manage your bond portfolio. In our case, investing in historically less-volatile equities allows the series to pursue a bond portfolio focused on downside protection and income.

“What you want is a portfolio that protects, that has lower volatility stocks and bonds, but that works to provide the growth that’s needed for a 30-year retirement,” she added.

To ensure they are getting such a portfolio, plan sponsors should consider reviewing the target-date series quarterly, measuring it against a benchmark and comparing it to the universe of other target-date funds, as well as the broad market.

“Once a plan sponsor understands how the glidepath was built and what it’s supposed to do, on an ongoing basis they should look at the results of the target-date series relative to a custom index,” Brown said. “How well has it done relative to that index and how do the results compare to the universe of other target-date funds? For example, say you have a target-date series, you know what the equity exposure is and there’s a market decline. If your fund goes down much further than you would have expected, you need to think about and evaluate that. Then you need to ask yourself: Is this what I expected? Is this what I wanted? Is this what the manager anticipated? And if not, why?”

In addition to a quarterly review, Brown suggested that plan sponsors do a deeper dive into their target-date offerings annually and consider other options at least every three to five years.

“It’s important that as fiduciaries, plan sponsors stay on top of those complex options,” she said. “And if there are any changes in the glidepath, any changes with the portfolio managers, ownership changes with the organization, change in philosophy, unexpected results of the target-date series — any of those things should trigger a very thorough review.”

Other issues that should lead a plan sponsor to review their target-date funds would be a change in the company’s benefits structure, such as closing or freezing their defined benefit plan, a change in ownership, a merger or acquisition, or a change in company management philosophy.

Large plan sponsors typically have an easier time reviewing their target-date funds because they will often have staff focused on the retirement plan or will use an investment consultant. Review becomes harder for smaller plans when the job falls to an employee who also has other responsibilities. That, however, is no excuse for a plan sponsor to take their eye off the retirement plan.

“That’s where having an investment advisor look at it, and making sure you have an investment policy statement is important,” Brown said. “And at an absolute minimum, do a pretty thorough deep dive once a year. It’s one of those things that you just have to commit to. There’s no easy way around it.”•

This sponsored investment insights is published by the P&I Content Solutions Group, a division of Pensions & Investments. The content was not written by the editors of the newspaper, Pensions & Investments, and does not represent the views of the publication, or its parent company, Crain Communications.