How to compare target date funds

As part of the Pension Protection Act of 2006, the Labor Department granted plan sponsors a “safe harbor” to enroll participants automatically in a handful of investment products designated as qualified default investment alternatives

As part of the Pension Protection Act of 2006, the Labor Department granted plan sponsors a “safe harbor” to enroll participants automatically in a handful of investment products designated as qualified default investment alternatives.

This ruling released sponsors from liability for losses resulting from the QDIA investments, provided that sponsors comply with Employee Retirement Income Security Act of 1974’s fiduciary rules when selecting and monitoring these vehicles.

Among the products approved as such investments were target date funds. Although many plan participants actively choose to invest in a target date fund, others find themselves in funds that are the default choice of their employers.

In fact, as of 2009, nearly 70% of defined-contribution plans used target date funds as their QDIAs, according to the 2010 Callan Defined Contribution Trends Survey. As such, it is crucial that plan sponsors — and advisers working on their behalf — be able to differentiate among the many target date funds available in the marketplace.

Traditional methods of evaluating investment products — such as relative benchmark performance and peer group rankings — have been largely ineffective when comparing target date funds. The use of systematically changing risk profiles and the broad variety of philosophies and processes suggest that target date evaluation needs to go beyond traditional measures.

In fact, there are two key factors that financial advisers should consider when comparing target funds. Understanding these factors will help advisers and their clients select a target fund best suited to plan objectives.

One of the most critical factors in the design of a target date fund is the methodology used to transition the equity and bond mix, and whether that transition stops or continues once the target date is reached. “To” retirement managers reach their most conservative equity allocation at the target date, while “through” retirement managers reach their final equity allocation after retirement.

Most funds are managed “through” retirement, reaching their lowest equity allocation as late as 15 to 30 years after the target date. These funds are designed to protect investors from longevity risk and tend to maintain high equity allocations at and into retirement.

Because a “through” manager’s equity landing point isn’t the target date, it is important to understand “when” the portfolio reaches its final equity allocation and what that final allocation will be, as both can vary significantly among managers.

Because participants’ nest eggs are most vulnerable to market downturns as retirement nears, “to” managers tend to focus on wealth preservation to protect investors against significant losses when they can least afford them. “To” managers also cite evidence that the majority of participants roll out of target date funds once in retirement, thus increasing the importance of wealth protection up until that point.

The difference in philosophy between “to” and “through” managers is the main reason that the greatest dispersion in equity allocations can be found near or past the funds’ target dates. In 2008, this dispersion led to large differences in performance results among 2000-2010 funds, where losses ranged anywhere from 9% to more than 40%.

By understanding each manager’s approach to this key feature of target design, sponsors can select a fund that is most closely aligned with the expectations and behaviors of their participants.

Although plan sponsors typically choose managers from multiple fund families to construct a plan menu, many target date funds use only managers from their own fund family. Open architecture employed in target date funds can offer sponsors certain advantages that should be considered when choosing among products.

These include access to top managers, reduction of single-manager risk, which diversifies away some institutional biases, and the addition of new asset classes, such as emerging-markets bonds and commodities. Firms managing their target date product with only in-house managers are unlikely to have products available in all asset classes.

Paul Zemsky is a chartered financial analyst and chief investment officer of multiasset strategies, and Susan Viston a senior portfolio specialist, at ING Investment Management.

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