Measuring the Unmeasurable

Lifecycle—or target-date—funds have been around long enough now to accumulate meaningful performance track records. Their popularity has been significantly enhanced by their acceptance as a qualified default investment alternative (see “QDIA Essentials“) option, and there is a rapidly expanding set of solutions for advisers to consider. What remains elusive as an industry standard is how these offerings should be benchmarked—and to what? John Barry, Principal of JMB Wealth Management Inc., asked a panel of target-date experts to sum up, in a sentence or so, their philosophy for analyzing target-date funds.

Matthew Cressy, Sales Director, Research & Indices at Lipper, said Lipper looks at the issue from a couple of different standpoints, but that the firm believes target-date benchmarks need to be “transparent, unbiased, and reachable.” Glenn Dial, VP, National Sales Manager at JPMorgan, noted that his firm had just launched a new tool: one that represents a step before the fund selection process, in that it is designed to help advisers help plan sponsors establish their priorities for these offerings. While the tool separates some 75 target-date series into four quadrants, Dial said that the main differences between target-date philosophies can be boiled down to two criteria: the percent of the fund held in equities at retirement (generally the 2010 fund in the series) and the number of asset categories in the fund.

Regarding the former, he noted that it ranges from as little as 10% invested in equities to as much as 70%. “I’m not saying one is better than the other,” he cautioned, “but there are differences.” He said the right choice depends on the plan sponsor’s goals and objectives and the plan participant behaviors and demographics.

On the other hand, Joe Nagengast, Principal of Target Date Analytics LLC, which has published the “Popping the Hood” series of reports evaluating target-date offerings, said his firm is “happy to grade and rank the funds.” He suggested, “When you are measuring target-date funds, you need to understand the objective.” The fund objective is important in determining and understanding the glide path and that objective will “help you determine how soon you have to apply the brakes, and how rapidly that will occur,” he noted. Nagengast also believes that objective should be stable, not “reoptimized” based on market changes. “The funds can optimize throughout the glide path,” he observed, “but the index itself has to be stable.” He said that his firm evaluates funds based on areas including fundamental research, risk control, and low cost—and that Target Date Analytics has recently launched a series of indexes based on those principles.

However, determining a fund’s objective can be problematic, according to the panel. Nagengast said that “prospectuses have interesting ideas about what will happen in the universe.” He said that half of the 34 funds included in “Popping the Hood III” had as their stated objective “to provide growth and preservation of capital over time in a manner consistent with asset allocation.”

Eric Loyd, Principal of Advanced Financial Strategists, Inc., said that his firm takes a more simplistic approach in evaluating these options with plan sponsors. On a quarterly basis, they download Target Date Analytics information, along with reports from Morningstar, and put the data into Zephyr. On an annual basis, they look at characteristics such as sub-asset categorizations and what managers/funds were added or changed.

Dial emphasized the importance of considering “prevailing circumstances,” and noted that the final QDIA regulations said that these offerings should be diversified so as to limit large losses. Moreover, he noted that the plan sponsor is not relieved of its fiduciary responsibility in selecting and monitoring a QDIA. Selecting one because it was “the only one offered on the platform” would not be a good standard, he said.

Dial noted that, as these funds add asset categories, “they tend to look like defined benefit plans, which have demonstrated better returns and diversification” over time than defined contribution plans. Cressy noted that, in a good market, returns on alternative assets were better, and correlations lower—and that “we’re going to see more target-dates adding those classes.” Still, he cautioned that “15 asset classes are not necessarily better than six or seven.” In fact, he noted, considering things like extra trading costs, “it could arguably be worse.”

Nagengast observed that this is “a new and rapidly developing industry” and that although, “in the past three years, diversification across the board has improved dramatically,” he believes the industry still has a way to go. “Currently, we’re still seeing funds giving up about 60 basis points annually through a lack of broad diversification,” he commented.

Still, as Dial put it, “The $64,000 question is: Are you managing to retirement date or death?”