Custom target-date funds are proliferating at the expense of their off-the-shelf counterparts, in part because plan sponsors want to have greater control over what's in a fund and have access to a wider array of investments to put in them.
Indeed, about 20% to 25% of plan sponsors with target-date funds are likely to switch to customized approaches by 2015, up from roughly 13% today, research and consulting firm Celent projected in a recent report.
The target-date fund category as whole has grown rapidly since the Pension Protection Act of 2006 helped establish them as a default investment option in 401(k) retirement accounts.
But dramatic declines in value during the 2008 financial crisis for investments that were supposed to get more conservative as participants neared retirement caused many investors and lawmakers to question their model. The worst performer that year among target-date funds geared toward near-retirees was Oppenheimer Transition 2010, which fell 41%, largely because two-thirds of its assets were placed in stocks, not bonds.
Customized approaches allow plan sponsors to choose multiple managers and replace them as necessary. They also give access to asset classes such as commodities, direct real estate, and hedge fund and private equity investments that retail funds may be prohibited from owning.
They also can charge lower fees to plan participants because of institutional pricing and give the ability to customize the so-called "glide path" for changing over to more conservative investments, depending on the demographics of a particular workforce.
But they're usually only available to larger plan sponsors because of the time and cost involved in setting them up and running them. Sponsors also assume additional fiduciary responsibility when they choose managers and tailor glide paths.
"As markets continue to demonstrate volatility, it's likely, though not guaranteed, that sponsors will look to these custom designs," says Alexander Camargo, the author of the Celent report.
Performance driving force
Camargo says that the lower costs and possibilities for customized glide paths were factors in their growing adoption, but the primary driving force is performance.
"Cost is important, but the main concern is performance - specifically, risk-adjusted performance," Camargo says.
David Wray, the president of the Plan Sponsor Council of America, says the rise of customized funds is a natural evolution of the target-date model.
"The ability to use a nonretail solution still requires scale, so it's not a surprise that the initial implementation [of target-date funds] has been pretty much retail," says Wray. "But over time, the amount of money [being managed] grows and becomes substantial, and that permits customization."
A plan sponsor looking to set up a custom solution will usually work with a consultant to develop a strategy and glide path, and choose managers. Then, the sponsor will pick an investment manager to help set up and run the funds. The big investment managers in the custom market are JP Morgan Chase, Black Rock, Pacific Investment Management, AllianceBernstein and State Street.
According to the Celent report, custom target-date funds are currently offered to plan sponsors with more than $500 million in assets. That's down from $1 billion just two years ago. The firm expects the bar will be lowered even further to $350 million over the next four years.
Wang writes for On Wall Street, a SourceMedia publication.
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