Rethinking Lifecycle Funds

“We are going through the next cycle of target-date fund [TDF] awareness,” says Doug Murray, director of sales and investments at Wells Fargo Institutional Retirement and Trust. “When target-date funds were first coming into prominence, some plan sponsors tied the target-date fund decision directly to the platform decision. Now there is a much more systematic view. Plan sponsors need to do a much more thorough evaluation, not just [ask], ‘What is the one-, three- and five-year performance?’”

For sponsors evaluating their plan’s target-date funds, also known as lifecycle funds, advisers can help bring clarity to these five areas:

1) Evaluate whether the glide path reflects the sponsor’s philosophy. Many sponsors initially just accepted their recordkeeper’s target-date funds and now need to decide whether these actually work best for that particular plan. “From a fiduciary perspective, the plan sponsor needs to take a step back and understand [the plan’s] objective,” says Tim Walsh, a TIAA-CREF managing director. “Is the plan meant to be an accumulation plan or a retirement-income plan?”

J.P. Morgan Asset Management offers the Target Date Compass, an adviser tool used to help a sponsor decide which of four target-date types works best for that plan, and then map out which particular managers mesh best with the employer’s plan goals and work-force needs. Advisers should help sponsors achieve a good sense of how they view risk, such as which type matters most for those participants, especially among longevity, inflation and market risks (particularly near or in retirement). “It does somewhat come down [to] a philosophical discussion and their tolerance for, at age 65, participants having a major market event and seeing their capital greatly reduced,” says John Galateria, a managing director at J.P. Morgan.

Market risk looms large in the strategy of some target-date providers. ING U.S. Retirement’s glide path begins more aggressively with equity than some because people have time to absorb the volatility, says Marianne Sullivan, head of investment information services. “As people approach retirement, our glide path tends to be more conservative than some others’. The five years or so prior to retirement are the most important in terms of downside risk.” And if someone’s account drops sharply a short time after retirement, she says, “it is very possible that he or she can never make up that loss.”

American Century Investments also relies on the “to”  approach. “Financially speaking, the riskiest day of your life is the day you retire,” Senior Portfolio Manager Richard Weiss says. “At retirement, you should be at your minimum risk posture. A target-date fund is built for the entire life cycle, to hold. But it does no good if the ride is so wild that an investor cannot, or will not, hold on.”

Others point to longevity risk. The glide path of TIAA-CREF’s TDFs, which focuses on the not-for-profit and higher-education markets, continues until age 75, Managing Director Randall Lowry says.

TIAA-CREF participant demographics explain the decision to continue the glide path past retirement. “The[se participants] have a longer life expectancy than the general population, so they have a heightened longevity risk,” he says.

Someone who retires at age 65 and lives until 90 needs another 25 years of asset allocation, says Jeff Tyler, a Principal Funds portfolio manager. “The ‘through’ retirement philosophy is essentially saying that retirement, while certainly an important event, is not quite the all-encompassing event that a lot of people think. A lot of people plan to be partially employed in retirement, and a lot of [actively employed] people do not know whether they will retire at 65 or at 70.”

2) Find out how participants actually use the retirement plan. Knowing whether a target-date fund still works well for a plan “really comes down to a sponsor understanding how the plan is being utilized,” Galateria says. For example, do most participants withdraw all their money at retirement?

Determining if a glide path still works best depends on factors such as the right risk posture for that participant group, Weiss says. “If you have a participant base that has, on average, saved well, has other retirement plans and can do a low withdrawal ratio, that argues for low risk,” he says. “If you have a group of investors who have not saved well and therefore will have to withdraw heavily on their assets early on, arguably they need a little higher risk posture.”

ICMA-RC specializes in working with public employees, and they have “modestly different” characteristics from average participants and frequently need to live off retirement savings longer than what is typical, says Wayne Wicker, the nonprofit’s senior vice president and chief investment officer. “We found that the retirement-age assumptions [in the public sector] are probably a little earlier than you might find in the private sector,” he says, where people often retire around age 60. “Forty percent of people who reach age 60 will live past age 90,” he says. “We felt that we need to continue to focus  
on accumulating assets for a period of time.”

3) Look into diversification strategies. A few years ago, target-date providers distinguished themselves with allocations to areas such as alternative investments. Now, many providers have added exposure to TIPS [Treasury inflation-protected securities], real estate, commodities and emerging-market stocks and bonds, Weiss says. “The differences are in the details—how much, and at what point in the life cycle, are you using them?” he says.

Differences at the asset-class level have become “fairly minimal,” Tyler agrees. “Over the next five years, [a big one] will be how people solve for the tail risk, or the risk of loss. What do they do to manage the volatility in equities? And how do they manage their fixed-income portfolio in a rising interest-rate environment?”

Some target-date providers have started utilizing tactical asset allocation to a degree that worries Weiss. “That is fraught with peril, in my opinion,” he says. “Tactical asset allocations have to be right more often than they are wrong, but they also have to be right on the bigger market-move days.” If a manager bets wrong on tactical allocation in a target-date fund, he says, that can destroy 20 years of savings for somebody about to retire.

J.P. Morgan’s target-date funds use the tactical approach to a modest degree. “The benefit is both achieving some alpha and protecting on the downside,” Galateria says. “The upside for sponsors is that, ultimately, your objective is to smooth the ride for participants.” And the glide path curbs a manager’s leeway to make big changes, he says.

4) Determine whether customized funds make sense. There is great interest among plan sponsors in customized funds, Galateria says, especially as plan assets grow. But he notes that adoption has been fairly slow so far, even upmarket. The practical challenges include the reality that a committee must agree on many things for a plan to put together custom target-date funds. And the operational challenges include the need to explain the customized strategy to participants. “It is not a complete no-brainer,” he says.

For now, custom funds are generally being introduced in the large-plan market. “You need to have the staff who can do the design work, or hire an adviser or consultant,” Sullivan says. ICMA-RC does not work with customized funds, for instance, because of the market it serves. “We offer a single glide path with a single methodology,” Wicker says. “We have a lot of small to midsize clients, and they are looking for us to use our best thinking.”

MassMutual Retirement Services sees increased utilization of its customized program, mostly by advisers serving as plan fiduciaries, says Tina Wilson, vice president of product development. “[A]dvisers whose value proposition is more focused on participants and getting better participant outcomes … are looking for off-the-shelf funds, because that is not their area of specialty,” she says.

5) Sort out the right active versus passive balance. A few providers such as Vanguard have virtually all-passive target-date funds, but a number of other managers offer a blend of active and passive management. Principal Funds tends to index 15% to 20% of its target-date portfolios. “My take on active versus passive is that there is not a blanket answer,” Tyler says. “Active is not always the right solution, and passive is not always the right solution. For large-cap blend equities, I will take the S&P 500, because it is really, really hard to consistently improve on the S&P 500. And there are only a few people who consistently outperform the Barclays Agg [bond index]—do I want to pay somebody 50 or 60 basis points to try? But in small-cap growth equity, there is a tremendous dispersion of opportunities and managers.”

ICMA-RC currently uses passive investments in core bonds and small- to mid-cap equity. “In the core bond space, we felt that is an area to get broad exposure. Getting that core exposure, having that diversification, is more important than generating alpha,”  Wicker says. As for using passive for small- to mid-cap equity—areas often cited as good for active management—he says, “that was the most cost-effective vehicle we could provide. We weigh the ability to generate excess return relative to the cost.” 

Others lean more heavily toward active management. J.P. Morgan uses indexing, “but it is not a predominant focus of our target-date funds,” Galateria says. “It goes back to managing risk. Whenever you are investing in an index, it is invested all-in in that index. The manager’s skill is taken out of the game. The only way they can manage risk is in the allocation to different asset classes, and that is primarily governed by the glide path.”

American Century focuses on active investment management, so it does not provide indexed target-date funds, Weiss says. “There are two issues with indexation in the target-date world. One is that you can index underlying investments, but there is no way to index a glide path, so you have to take an active stance on what is the biggest decision in the target-date structure,” he says. “Second, there has never been any evidence that active mutual funds are outperformed by indices, other than in large-cap U.S. equity.”

Lifestyle Funds: Option, Yes; Default, Probably Not 

Target-risk funds do not get nearly as much hype as target-date funds, but they still play a role in many plans.

Thirty-nine percent of employers surveyed by consultant Aon Hewitt for its 2012 Hot Topics in Retirement survey have a target-risk fund—also known as a lifestyle fund—in the lineup, and 16% of other employers said they were very or somewhat likely to start offering them this year.

“Target-risk [funds] certainly [have] been overtaken on a flow basis, but they are still out there,” MassMutual Vice President Michael Eldredge says. MassMutual has four risk-based funds and finds that some clients, such as Taft-Hartley plans, appreciate the static nature of the glide-path combined with different risk-level choices.

“They beauty of risk-based portfolios is that you can get a lot of different flavors at once,” says ICMA-RC’s Wayne Wicker.

But, unlike the one-stop shopping of target-date funds, target-risk funds put the onus on participants to pick which flavor suits them best. It can work well if participants get personalized advice—such as from an adviser. “Particularly if a participant is working with an adviser, the adviser can help the participant make a better decision on the risk level,” ING’s Marianne Sullivan says. “And they can take into account outside-assets.”

However, risk-based funds are used as the default much less often than target-date funds. “The appeal of target-date funds is that it is easy to move to automatic enrollment and put somebody into a target-date fund based on age,” Wells Fargo’s Doug Murray says. “In getting your recordkeeping file, I know your age. I do not know your risk tolerance. It is easier for participants to get into the right target-date fund than into the right risk-based fund.”

“To my mind, the default is for people you cannot engage,” Sullivan says. “That does not play well to risk-based funds.”