The unique nature of target-date fund benchmarking

Target date funds have quickly become one of the most popular asset classes in defined contribution plans, beginning a meteoric rise in popularity following rules codified by the Pension Protection Act of 2006.
Cerulli Associates, a research firm, estimates that target date funds will capture nearly 90% of new contributions to 401(k) plans by the end of 2019, and will represent around 35% of 401(k) assets. Currently, 13% of 401(k) plan assets are invested in target date funds, beaten only by company stock and actively managed domestic equity funds, according to the Plan Sponsor Council of America.
It’s becoming increasingly important for advisers to properly evaluate target date funds, the most common default fund, for specific 401(k) plans.
Yet, target date funds are a different animal from other 401(k) investments from a benchmarking perspective. As opposed to other funds on an investment menu, target date funds are meant as a one-stop shop for all of a participant’s contributions, which isn’t the case for other funds, plan advisers say.
“Target date funds cannot be benchmarked similar to core investments inside of the retirement program, and they’re probably the most important decision that the plan sponsor has,” said Jamie Greenleaf, lead adviser and principal at Cafaro Greenleaf.
Target date funds are a suite of multi-asset-class funds whose asset allocation shifts from aggressive to more conservative as an investor approaches retirement. A glide path is how that asset allocation shifts over time.
The in-flux nature of the glide path, differences in managers’ mix of stocks and bonds and allocations to different underlying style categories (some managers may use high-yield bonds or alternative asset classes, for example) make target date funds unique, advisers say.
“[Benchmarking] is way more complex than with other asset classes because there is no homogeneity and there’s no single accepted approach,” said Jon Chambers, managing director at SageView Advisory Group.
DEMOGRAPHICS
Advisers should start with a plan’s demographic makeup and participant behavior when gauging the perfect target-date fund suite for a retirement plan. Even though this is considered a best practice, not many advisers benchmark this way, according to Fred Barstein, founder and chief executive of The Retirement Advisor University.
“It’s meant to be the one fund you put all your money in, not an ingredient,” Mr. Barstein said. “It’s the difference between saying, ‘I want to make sure the ingredients I make available for people cooking their meals are clean and healthy’ versus ‘I’m going to serve a meal for everybody and everyone will eat the same meal.’ It’s a different evaluation.”
A participant base that skews younger, for example, may warrant target date funds managed by an equity specialist firm, because the majority of participants would be in longer-dated funds with higher equity exposure, Ms. Greenleaf said; conversely, a fixed-income specialist could be better suited for an older population.
If a company also offers a pension plan, and the 401(k) is meant more for supplemental savings, a conservative target date fund suite may make more sense because there isn’t a need to be as aggressive, advisers said.
Advisers should couple demographics with the philosophy and goals of the plan’s investment committee — for example, whether funds seek to capture upside or perhaps reduce downside volatility, Ms. Greenleaf said.
That narrows the field of appropriate fund families to a handful; those serve as a benchmark for the suite ultimately chosen because it’s an apples-to-apples comparison, Ms. Greenleaf said. There are currently more than 50 mutual fund series on the market, with approximately $725 billion as of Sept. 30.
Providers such as Morningstar Inc., Dow Jones and Standard & Poor’s publish target date fund indices advisers can use to help benchmark funds.
However, indices are typically built at the midpoint of a peer group of funds, which won’t be as helpful for funds with wide dispersions in asset allocation, Mr. Chambers said. He also cautioned that the indices don’t show if a fund’s deviation is due to good or bad management, or a difference in underlying asset allocation or sub-asset allocation.
INVESTMENT CHARACTERISTICS
Just because the fund matches the demographic and behavioral makeup of a plan doesn’t mean it’s a decent fund to use, according to Mr. Chambers. “I see demographic and investment characteristics as kind of co-equal,” he said.
Investment characteristics, such as a total return, expenses, risk-reward profile, downside correlation, exposure to different asset classes, glide-path equity exposure, stability of credit quality, upside correlation, inflation hedging, manager tenure and underlying investments, are all things to consider, Ms. Greenleaf said.
Chris Karam, chief investment officer at Sheridan Road Financial, said his firm is in the process of enhancing its approach to the investment portion of analysis to determine the sources of over- or under-performance. For example, is good performance attributable to asset allocation favoring U.S. over international stocks, or to active-manager risk?
“We feel that it’s a best practice from a fiduciary perspective to have a handle on the underlying components of TDFs,” Mr. Karam said. “It’s one way to not only identify the source and attribution of the return, but then to be able to go back to that target-date manufacturer and ask questions about their process surrounding the supervision and monitoring of the underlying funds.”