Defined contribution retirement plan sponsors are currently selecting target-date funds (TDFs) in a handful of ways, said Nathan Voris, director of sponsor and workplace solutions at Morningstar Investment Management, speaking during a webcast on “Optimal Glide Paths for Defined Contribution Plans.”

Typically, they rely on the proprietary series that their recordkeeper offers, Voris says. They also seek out the cheapest TDF series or try to find those with strong historical performance. “Fees are important but should not be the primary factor,” Voris says. “And because of the changing asset allocation in TDFs, it is hard to track their historical performance.”

Instead, he says, sponsors should focus on four “layers of methodology,” in this order. “First, glide path design, followed by asset class exposure to ensure it is appropriately diversified, including fixed income,” Voris says. Next, “the asset allocation methodology and how the allocations in the glide path change over time. Lastly, whether it is active, passive or both. Because the latter is an easy conversation, many sponsors have moved that up to the front of the list, but it is our perspective that this should be the last order of business.”

Since the glide path is the most important factor when selecting a TDF, Morningstar Investment Management believes the first order of business for sponsors and their retirement plan advisers when selecting the appropriate glide path for their plan’s demographics is to determine the participant population’s “risk capacity,” says Lucian Marinescu, director of target date strategies. “A younger workforce has a higher level of ‘human capital,’ which is the value of future earnings, while an older population has a greater level of ‘financial capital,’” Marinescu says.

NEXT: The key participant data

In order to determine this risk capacity, sponsors need to anonymously collect key data on each participant, namely: age, balance, salary, contribution and defined benefit (DB) plan (if applicable), Voris says. Then, sponsors can use Mornginstar’s Glide Path Selection Tool to generate individualized recommendations for each participant, says Daniel Bruns, manager, large market at Morningstar Investment Management. The tool shows the recommendations on a scatter plot that includes the trajectory of the average glide path for all of the participants. This is then overlayed with the glide paths for the three Morningstar Lifetime Indexes—aggressive, moderate and conservative—to determine which is the best fit, Bruns says.

Morningstar Investment Management then illustrated four case studies. For a large manufacturing firm with lower than average salaries, average balances and slightly higher than average deferrals, the tool showed that the desired participant equity risk most closely aligns with the Morningstar Lifetime Moderate Index, Voris says. For a leading technology firm with higher than average salaries, balances and deferrals, the Morningstar Lifetime Aggressive Index is the best fit, Marinescu says.

The third case was a national retailer with lower than average salaries, balances and deferrals, for which the Morningstar Lifetime Conservative Index is the best fit, Bruns says. Finally, the fourth case was a large medical practice with a wide range of salaries between the administrative staff and the doctors. Although this plan’s workforce has above average salaries, balances and deferrals, because of the 25% dispersion, custom target-date funds or managed accounts would be the most appropriate choice, Voris says.

As Morningstar Investment Management notes in a white paper it recently issued, “The Glide Path Selection Problem,” “significant differences within products make the target-date decision perplexing for even the sophisticated investment committee. The most reliable method for assessing the risk capacity of a plan is to perform a quantitative analysis of the plan’s participants, to determine the risk capacity, or appropriate equity exposure, of a specific plan. With so many assets flowing into target-date funds, it is imperative that plan sponsors diligently select the glide path most appropriate for their participants.”

The Morningstar Investment Management white paper can be downloaded here.