How to best understand target date fund options

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Thanks to the overwhelming popularity of target date funds as a 401(k) qualified default investment alternative, competition among retirement plan asset managers for TDF dollars has been stiff. But as the Department of Labor emphasized in guidance issued way back in 2013, plan sponsors need to ask a lot of questions to be sure they understand how a TDF family is managed to know whether it’s appropriate for their participants across the entire age spectrum. Customized TDF solutions give sponsors more options, but also add to the challenge of settling on the best ones. To gain an update on TDF choices and assessment, Employee Benefit News recently spoke to Jake Gilliam, CFA, a senior multi-asset portfolio strategist for Charles Schwab. Highlights of that conversation follow.

EBN: In your experience, how carefully are plan sponsors looking “under the hood” today to understand the inner-workings of target date funds?

Jake Gilliam: Without a doubt there has been an increase in plan sponsors’ efforts to better understanding their target fund. They know it’s something that requires ongoing review and reevaluation to make sure that their original choice is appropriate for their participant demographics. The guidance from the Department of Labor back in 2013 helped to focus attention.

EBN: How are they evaluating performance?

Gilliam: Many sponsors are looking carefully at the actual drivers of performance, as opposed to seeing the numbers by themselves. So that’s led to conversations about the glide path, the actual components used to implement the glide path, ranging from the underlying strategies of the funds, the types of risk exposures, how asset allocation changes over time and more.

EBN: When you talk about asset allocation changing over time, are you just talking about a basic stocks/bonds/cash allocation, or sub-allocations within the stock and bond components?

Gilliam: The asset allocation nuances now that are part of conversations are within stocks and within bonds — what are the actual components being used, how do those change over time, are they a static allocation, or are they truly matching risk tolerance, not just at the stock/bond level, but within stocks.

EBN: So what are sponsors asking for, or what are you doing in that regard?

Gilliam: Things like increasing large cap exposure for people nearing retirement to help limit their overall volatility and really protect the accumulation they worked so hard for during their working years. These asset allocation differences and what may seem like small nuances during the selection process can really lead to significantly different outcomes over time, and that has a direct impact on participants’ lives.

EBN: Can you expand on what kind of nuances you are referring to and the impact they can have?

Gilliam: It’s actually more than nuances, and these assets have very wide variances in performance. Variances in the U.S./international stock allocation ratios can lead to double-digit performance differences in any given year. That can directly influence the ultimate result for the portfolio, but its impact on volatility is also important from a participant perspective. It’s important for the asset mix to be appropriately aligned with the risk tolerance of an investor, to support good behaviors by participants.

EBN: Good behaviors?

Gilliam: By that I mean remaining invested, not fleeing the market after dramatic volatility, and ultimately not accumulating enough by retirement.

EBN: Obviously there’s a lot for sponsors to think about. How much should they try to dictate all the parameters of performance when shopping for a TDF family?

Gilliam: There is a practical limit. Most plan sponsors are using a target fund that was designed by a target fund family. One of the parameters that sponsors also need to keep in mind is cost. But generally they are by and large using a target fund provider’s existing target date fund and they’re selecting the one that best matches their participant demographics.

EBN: How much latitude should TDF providers be given to change their allocations and asset subcategory investment mixes?

Gilliam: There are some providers that will have a tactical allocation allowance where they can move in shorter time periods and change the composition of the portfolios for short-term horizons. And then there are others that are really built for the long-term that will change over time to proactively respond to market conditions, but aren’t changing on a daily, monthly or quarterly basis. The plan sponsor needs to understand the type and the frequency and the outcome of these types of decisions. When we have conversations with them, they understand the drivers of long-term performance, they aren’t surprised by short-term deviations.

EBN: How do sponsors assess the impact of the higher costs inherent in active management of equity portfolios?

Gilliam: We want sponsors to clearly understand the differences in how investment strategies are implemented, and to know that performance comes in cycles. Sometimes passive strategies outperform active, and vice versa. So for some sponsors a blended approach can make sense. Cost is one factor, but it’s not the only factor that’s important in selecting a qualified default.

EBN: Can you illustrate how allocations within the fixed income bucket can shift over time as the participant’s retirement date draws nearer?

Gilliam: The younger investor may have more exposure to higher yielding securities, securities in areas in the fixed income market that may have additional volatility but that can support accumulation and growth when a participant can tolerate that volatility. However, as they age and near retirement, some target funds will introduce asset classes within the fixed income allocation like inflation-protected securities. They will decrease those higher yielding securities with a higher default risk and greater price volatility, in favor of treasuries, agencies and other debt securities that generally do well in times of market stress, as well as provide liquidity.

EBN: But don’t retirees have a greater need for income? Doesn’t that put pressure on bond portfolio managers to keep some higher-yielding bonds in the mix?

Gilliam: We’re focused more on the overall risk represented by the fixed income allocation. Knowing that there are a number of different needs in retirement, we first set out to make sure that the glide path and its underlying mix can help support long-term withdrawals under different scenarios.

EBN: How do you assess the level of risk a particular portfolio model represents?

Gilliam: We’ll evaluate 6 percent, 5 percent, 4 percent inflation-adjusted withdrawals year in and year out to understand the success rate, and how long someone can live off of their accumulated savings. With fixed income we want plan sponsors to understand if it’s structured to protect those nest eggs or if it’s still structured to seek additional yield at the expense of volatility. That’s a question that we’re encouraging plan sponsors to ask because the yield environment has been in such a prolonged low state. If the fixed income allocation is seeking yield or exclusively relying on active managers that will underweight government type securities, the net fixed income allocation may not be as safe as plan sponsors expect it to be.

EBN: Can you talk about risk reduction within the equity side of the portfolio? Are there any common misperceptions?

Gilliam: There are mixes that shift over time, for example, such as increasing domestic equity’s share relative to international equities. The idea is to draw a tighter correlation to the liability stream of the participant. Also within the U.S. component, pulling back on small and mid-cap stocks and being more heavily invested in larger cap stocks to provide a smoother ride for participants, while still being able to generate enough return to help offset inflation.

EBN: How practical or affordable is it for smaller plan sponsors to get customized TDF portfolios?

Gilliam: No matter the size of a plan, having these discussions and making that active choice between going with a traditionally considered passive, active or blended option, or considering custom, that conversation is vitally important. Because no matter the size of the plan, all participant dollars are incredibly important. We’ve seen costs and size requirements come down for very sophisticated prepackaged portfolios. Smaller sponsors can use them or consider partnering with a consultant to build a custom solution.

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