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Northern Trust Takes a LDI Approach for its TDF Glidepath
When benchmarking a target-date fund (TDF), “the key point is to shift the focus from
measuring the fund against a custom index to actually meeting the goal of achieving
equal consumer discretionary spending pre- and post-retirement,” says Sabrina
Bailey, global head of retirement solutions at Northern Trust Asset Management
in Chicago.
“The defined benefit (DB) world has been using this approach for decades, and
after the passage of the Pension Protection Act, their view of liability-driven
investing increased significantly,” Bailey says. “In the DC [defined contribution]
construct, the liability is the target retirement income and measuring the
savings rate to keep up with that liability. For example, if an individual is
on track for retirement or a plan sponsor has a strong plan design, they could
take less risk in the investment portfolio and still achieve equal consumer
spending pre- and post-retirement while avoiding a down market.”
Northern
Trust outlines this more conservative approach to creating a TDF glidepath in
its white paper, “What’s the Funding Status of Your DC Plan?” The paper states: “Assets
within a DC plan should serve a purpose, and that purpose is not to accumulate
a large amount of excess assets over one’s working career. A DC saver’s excess
assets may likely be used more effectively elsewhere during the accumulation
phases, i.e. to pay down debt prior to retirement.”
“Additionally, well-documented behavioral research studies indicate that the
pain retirement savers experience from investment loss is greater than the joy
derived from equal upside gain. Therefore, TDF investments should aim to meet the retirement liability, as opposed
to exceed the liability,” according to the Northern
Trust white paper.
To accomplish this, Northern Trust’s TDF series, its Focus Funds, have a
proprietary Income Replacement Rate Framework that allows the firm to determine
the appropriate replacement rate for participants in different DC plans, Bailey
notes. To accomplish this, Northern Trust “looks at what participants are
making today; what they are saving; balances ; the plan design, including
company matches, deferral rates and escalation; taxes; and the average
retirement age,” she says.
Thus, as opposed to off-the-shelf TDFs that
might predetermine an income replacement ratio of 75% or 80%, for a particular
plan, Northern Trust might determine that it is actually 78%, and that will
then let the asset management team know what the asset allocation should be for
that particular plan, or even build a custom TDF, Bailey says.
NEXT: Goals-driven investing
Northern
Trust’s TDFs are also built to provide downside protection, according to another white paper by the firm, “Glidepath Innovation to Drive Better Participant Outcomes.”
The paper states: “Our glidepath design and construction process utilizes our
asset allocation philosophy, which builds on the importance of financial asset
diversification, global equity diversification and inflation sensitivity.
“Financial assets, which include both risk control and risk assets, are
diversified to potentially reduce volatility and seek to protect against
downside market events. We employ these methodologies in a goals-based
framework called goals-driven investing (GDI),” the firm says.
Northern Trust’s portfolio managers then look at a five-year forecast for
economic activity and market returns. “Additionally, we consider a qualitative
lens where, each year, key themes emerge that we believe will affect the
economic and financial market landscape,” Northern Trust says.
The Focus Funds are also designed to take a participant through retirement,
Bailey says. According to the firm’s DC funding status white paper, that is up
to age 95. Northern Trust then “empirically encodes the federal tax code” into
its TDF model, to account for tax, Social Security and health care” into the
funds’ glidepath, Bailey says.
The Northern Trust Focus funds also “take lifecyle expenses into consideration
by relying on academic studies and economic research” into spending patterns in
retirement, Bailey says. Another key component is “human capital—but Northern
Trust looks at human capital in a different way than our competitors,” she
says. “We look at the present value of future savings in order to reach an individual’s
retirement goals. Imagine you are participating in your 401(k) plan and saving
$100 every two weeks. That is what we consider the human capital. It is a
bond-like investment because it is contributed on a regular basis. The
consistent savings allows you to take more risk in equities.
“As you get closer to retirement, the number of contributions will decrease, so
we offset that with an allocation to a bond-like portfolio that has more income
characteristics,” Bailey continues. “That drives our glidepath and goals-driven
investing. The whole concept is to move away from a risk/return framework to
look at the income the TDFs will provide.”
As Northern Trust notes in its funding white paper: “The objective for any target date fund should simply be to efficiently fund the retirement liability, enabling participants to reach those goals—not to outperform an index, generate higher total returns than other mangers or take unnecessary risk to grow assets in excess of the liability.”