Glide Paths Should Drive TDF Selection

Most retirement plan sponsors simply rely on what their recordkeeper offers, Morningstar Investment Management says.

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.”

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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.

Retirement Plan Participation Continues to Improve

However, average deferral rates have declined slightly from their peak of 7.3% in 2007, Vanguard finds.

In large part due to automatic retirement plan design features, aggregate participation rates are higher than ever and continue to rise, according to Vanguard’s 15th anniversary edition of its How America Saves report.

Since this year marks the 10th anniversary of the Pension Protection Act (PPA), Vanguard’s report includes findings that reflect the impact of the law on improving plan construction and participant investing behaviors in defined contribution (DC) plans over the past decade. For example, among its provisions, the PPA enabled the automatic enrollment of workers into 401(k) plans at a default savings contribution rate, as well as the auto escalation of workers’ contribution rates on a periodic basis. As of year-end 2015, 41% of Vanguard plans had adopted automatic enrollment, up from just 10% of plans a decade ago. Of those plans, 70% featured automatic annual increases.

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Last year, 63% of new Vanguard participants were hired under automatic enrollment, versus 12% in 2006. In 2015, three-quarters of eligible employees participated in their employer’s plan, up from two-thirds ten years ago.

The PPA also sanctioned the use of target-date funds as a qualified default investment alternative. Target-date fund use has nearly doubled since the passage of the PPA, with 90% of Vanguard plan sponsors offering target-date funds at year end 2015. In aggregate, 98% of participants now have access and 70% of participants use target-date funds.

“Target-date funds are, without question, a game changer and one of the most important elements of the 401(k) evolution,” says Jean Young, lead author of How America Saves. “As defined contribution plans evolved, it was clear that many workers were not going to serve as their own investment manager. As a result of the rise of target-date funds, we’ve seen dramatic improvements in the portfolio construction of 401(k) participants.”

NEXT: Improvements can be made

Looking ahead to the next decade of the post-PPA era, How America Saves data points to key areas needing improvement. In particular, the rise of automatic enrollment has had an inverse effect on deferral rates. Nearly three-quarters of plans default at participant at savings rates of 4% or less. Automatic enrollment boosts participation rates, but it can lead to lower contribution rates when default deferral rates are set at insufficient levels.

According to the report, high-level metrics of participant savings behavior remained steady in 2015. The plan participation rate was 78% in 2015. The average deferral rate was 6.8% and the median was essentially unchanged at 5.9%. However, average deferral rates have declined slightly from their peak of 7.3% in 2007.

The rising adoption of automatic enrollment also results in a growing number of smaller balances. In 2015, the average account balance for Vanguard participants was $96,288; the median balance was $26,405. In 2015, Vanguard participants’ average account balances declined by 6% and median account balances fell by 11%.

“Plan sponsors—and the industry as a whole—must bear the responsibility to continue the significant progress impelled by the PPA, including driving improved savings rates for all participants,” says Martha King, managing director of Vanguard’s Institutional Investor Group.

This year’s How America Saves report is here.

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