Looking inside target date funds
Financial advisers who handle retirement plans have noted that plan sponsors are now very much aware of the performance of target date funds. But sponsors don't really understand the reason for the performance, according to 76% of advisers polled by my firm.
Financial advisers who handle retirement plans have noted that plan sponsors are now very much aware of the performance of target date funds. But sponsors don’t really understand the reason for the performance, according to 76% of advisers polled by my firm. They thought that plan sponsors only sometimes, rarely or never recognized the differences in glide paths among these funds.
This spells opportunity for advisers. Although designed to shift automatically to a more “conservative” mix as the participant’s expected retirement date approaches, target date funds apply no standard definition of “conservative.”
As a result, some 2010 funds have an equity allocation of as much as 65%, while others have an allocation closer to 20%.
These stark differences in equity allocation and asset class diversification have come under scrutiny. The 2010 funds with the most aggressive equity allocations are down more than 30%, leaving participants planning to retire within the next 12 months with steep portfolio losses at a time when they need these assets, or significant financial flexibility, the most.
Most sponsors clearly lack the knowledge and framework with which to effectively evaluate and select the appropriate target date funds. Just one in four advisers thought that plan sponsors had clear criteria for selecting the target date funds most closely aligned with plan goals and participant behaviors.
Although advisers appear to be taking the time to clarify goals, discuss evaluation criteria and educate plan sponsors on the differences among target date funds, 78% of advisers surveyed acknowledged that sponsors placed too much emphasis on fees when selecting funds or, ultimately, chose funds based solely on their record keeper’s recommendations.
Additional survey findings illustrated the relative level of attention paid to target date fund volatility: 76% of advisers said it was ex-tremely or very important to consider strategies that incorporate broad diversification of asset classes; 67% said it was extremely or very important to manage volatility in the five to 10 years prior to retirement; and 61% said plan sponsors’ objective was to meet income replacement goals at retirement versus 39% who said plans were trying to maximize participant’s lifetime savings.
Recent target date fund performance will continue to focus heightened attention on sponsors’ evaluation practices and participant outcomes.
We think that minimizing risk in the five to 10 years before and immediately after retirement is crucial to helping as participants cross the retirement “finish line.”
To accomplish that, sponsors need to ensure that they define their plans’ goals and select funds well-suited to participant saving behaviors and demographics. Advisers have a unique opportunity to guide sponsors through the process of identifying these factors and ensuring appropriate target date fund selection.
We recommend that advisers consider these evaluation steps:
• Define plan goals. Start by determining the plan’s objectives in relation to participants’ account balances. Is it to minimize downside risk and the effects of market volatility at retirement or to maximize participants’ savings through their lifetimes? This decision will influence the level of equity allocation in the crucial five to 10 years prior to retirement.
• Help plan sponsors understand the trade-off between performance and volatility. Educate sponsors on the choice between maximizing returns versus managing volatility — particularly as participants near retirement. Incorporate these considerations into the evaluation process and consider solutions that may be effective at achieving competitive returns while minimizing excess volatility.
• Highlight the differences among fund glide paths.
• Demonstrate a prudent evaluation process. Selecting target date funds without engaging in a prudent process can be risky. Assist sponsors by following a process that evaluates and compares target date funds based on their fit with plan goals and participant needs and analyzes them using more traditional quantitative and qualitative investment screens.
We think that this process can help fiduciaries fulfill their legal responsibilities for target date fund selection and allow them to meet obligations under the Employee Retirement Income Security Act of 1974 by providing a framework in which to effectively evaluate the most appropriate funds for their plans and participants.
David L. Musto, a managing director at JPMorgan Funds in New York, is in charge of its retirement business.
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