An Elusive Target
When the U.S. Department of Labor (DoL) released the final regulations for choosing a qualified default investment alternative (QDIA) (see “Default Vault,” Winter 2007), target-date funds were sitting pretty atop the list of appropriate choices as a default option. Too bad the regulations say nothing about how to evaluate them on an ongoing basis.
“It says zip about benchmarking,” says James Delaplane, Jr., a Washington-based partner at law firm Davis & Harman LLP. “Plan sponsors are left to traditional fiduciary principles.” They and their advisers can look at the underlying funds in each target-date fund and gauge those, he says, or they can benchmark against other target-date funds. Yet, how, over what period(s), and against what criteria have yet to be established for this fast-emerging 401(k) menu staple.
There is significant work being done in the industry right now around target-date benchmarking, Delaplane says. “The consulting world and the product-manufacturer world are scurrying to come up with these tools,” he says. “In the next 12 to 18 months, we will have new tools and metrics.”
Target-date funds have other issues that make benchmarking a challenge, such as a relatively brief performance history and the wide range of asset allocations—both among providers and among different retirement dates. “It is hard to say that one is right and one is wrong, because investors are in different situations,” says Rod Bare, Director, Asset Allocation Strategies, at Morningstar Indexes. “There will continue to be several variations of asset allocations needed to serve the various profiles of investors out there. I do not think it is possible, or desirable, to have one answer for everyone.”
Some see headway being made, though. The same target-date benchmarking tools remain, but people are figuring out how to use them, says Jim Lauder, Chief Operating Officer of Atlanta-based Global Index Advisors, Inc. “There is never going to be a perfect benchmark, but there is progress in using the tools we have.”
Some advisers have decided to develop their own target-date fund evaluation methodology. Tess Malone and her colleagues at Blue Prairie Group, LLC, face the challenge of gauging these rapidly growing funds at the same time the industry lacks agreement on how to do it.
“It is an interesting dilemma, because this asset class is likely to be the dominant investment vehicle,” says Malone, a Chicago-based consultant at the human-resource and investment-consulting firm. So, she and her colleagues are working on a new, enhanced version of their proprietary performance evaluation system that may include creating customized peer groups in 10-year increments.
Using existing third-party tools that make assumptions about investing patterns can be challenging, Malone says. “You really have to address the differences in asset allocation [among various fund families],” she explains. “If [the benchmark] is not a good match for the asset allocation, then it is kind of irrelevant.”
Blue Prairie Group staffers believe the industry needs to add a new metric that goes beyond traditional fund benchmarking: They want to evaluate the probability that a target-date fund will provide enough income for a participant in retirement. Malone says, “The ultimate criterion is: What is the likelihood of success for that particular investor in that particular fund?” For an adviser and sponsor choosing a target-date fund family, that could involve looking more closely at several funds’ glide paths in the decumulation phase, incorporating assumptions about participants’ behavior based on experience in areas such as withdrawals, and using computer models to test which glide path works best for that participant group.
The current focus on retirement income does not stem directly from the QDIA regulations, Delaplane says, and has more to do with factors such as aging Baby Boomers and the decline of defined benefit plans. However, the regs “went out of their way” to make clear that, if underlying funds otherwise qualify as a default, having income and insurance features does not disqualify a target-date fund family. “The QDIA provides an opportunity to bring an income solution to a broader group,” he says.
Key Qualitative Factors
Without industry consensus, how should advisers approach target-date benchmarking? Before talking about returns with sponsors, Robert Goldstein and his colleagues at StoneStreet Equity address other analytic keys to benchmarking. “We do not believe that just measuring historical performance against a benchmark is a meaningful way of measuring target-date funds,” says Goldstein, a Principal at the National Retirement Partners firm based in White Plains and Pearl River, New York.
Says Malone, “What quantitative metrics do not tell you is how the performance was arrived at. It is the qualitative metrics that give us a better handle on what is going to happen in the future.” Since target-date funds are funds of funds, advisers need to evaluate the underlying funds carefully. Get a good grasp of their style consistency, Malone recommends. “Are they style-pure, or is there a history of those funds being inconsistent?” she asks. That information tends to be readily available when mutual funds are the underlying investment, somewhat less so with underlying separate accounts, and can be challenging to get with commingled funds, she adds.
Underlying fund construction can vary considerably. Are the individual target-date funds made up of registered mutual funds or separate account pools? Are funds institutional, or retail? Do the managers pick best-in-class funds from other firms, or go with proprietary products? Do they use index funds, or active management?
Keep close tabs on the investing choices, too. Equity picks can be aggressive or conservative, and the same holds true for bonds. Also, does a fund stick to equities and bonds, or include diversifiers such as alternative investments? Does a fund have a balanced style or tilt toward value or growth? Does it have a strategy for keeping pace with inflation, such as including TIPS in the portfolio?
In addition, monitor glide paths carefully. “There are dramatic differences in funds,” Malone says. “You have to look at not only what it is today, but also what it is going to be 20 or 30 years from now.” Make sure the allocations make sense for a plan’s participants all across the age spectrum.
Analyze the equity exposure and how it changes during the accumulation and distribution phases, and know when a glide path terminates. Some providers make the allocation static starting at age 65, Goldstein says, while others push it out to 80 or 85. Prior to the market correction, he says, many fund managers seemed influenced by studies showing participants more concerned with longevity and a potential savings shortfall than with volatility. He believes that led them to invest more heavily in equities, even past the retirement date. He has not seen this yet, he says, but trends like that frequently lag market corrections.
Also, Bare recommends, keep a close eye on these funds’ fees. “Some providers are charging 120 to 130 basis points, and others are charging 50,” he says. “The investment horizon here is so long, if you let 50 or 60 basis points a year slide by in fees, that adds up to shaving off seven years of income in retirement.”
Last but not least, get a good sense of a fund’s risk and volatility. “Is it trying to maximize return, or is it working toward a risk budget?” Bare asks, and he suggests focusing on the longevity risk. Do the target-date funds have a strategy in place to address it?
The QDIA regs do not say how much volatility is acceptable and how to measure it, Delaplane says, beyond making clear that a default investment needs to have a mix of equity and fixed income. So, a target-date fund used as a default cannot be 100% in equity.
Benchmarking performance with a universe and index helps when doing a target-date fund evaluation, Lauder says, but neither matters as much as ensuring that a plan and the funds’ managers share a risk orientation. “Make sure that the set of funds adheres to the agreed-on philosophy of risk,” he says. “To me, the first step of evaluating these funds is saying: “What kind of philosophy is most helpful for your participant base?””
A New Index Tool
If an industry consensus is still lacking, potential solutions nonetheless are emerging. Advisers can utilize a target-date fund universe, comparing a fund to a group of peers. “You have a growing proliferation of universes,” says Joseph Nagengast, a Marina del Rey, California-based Co-Founder of Target Date Analytics. He cites tools from Morningstar and Lipper as well as the big consultants. “You can compare any given fund to all the other funds trying to do the same thing,” he says.
While a legitimate approach, Nagengast says, it has drawbacks. For instance, say an adviser looked at performance among a universe of funds for the past three years, as of December 31, 2007. “There are funds close to 70% in equities that will trounce anyone’s performance. All they had to do was have more in equity, and they would win,” he says. However, winning in the short term is not the long-term objective of a target-date fund, in Nagengast’s opinion. “The preservation of purchasing power has to be the primary objective,” he says, “and, if you look at the last quarter of ’07 and the first couple of months of ’08, those performance positions flipped.”
Advisers also can use an index, and those who want a third-party tool have several options. Dow Jones & Co. offers two index-measurement options: The Dow Jones Target Date Indexes, a family made up of composite indexes that include stocks, bonds, and cash; and the Dow Jones Real Return Target Date Indexes, which include those three asset classes as well as TIPS, commodities, real-estate securities, and U.S. nominal bonds.
Dow Jones’ benchmarks intend to measure target-date funds’ performance in delivering on their original promise, says Lauder, whose firm developed the indexes: taking investors from accumulation to preservation with an appropriate amount of money that lasts. “This is what we believe is the ideal product in an ideal world,” he says of the indexes.
Target Date Analytics’ Pure Target Series takes a different approach by offering 24 indexes across four index series that reflect differing investing orientations: defensive, conservative, moderate, and aggressive. Each includes six target-dates: current/today, 2010, 2020, 2030, 2040, and 2050.
Look at 2010 fund offerings in the marketplace, Nagengast says, and one may have an equity allocation as low as 20%, while another goes as high as 70%. “Part of the problem is that, if you build a benchmark and somebody’s approach is so different, then none of your analytics will be meaningful,” he says.
Summer will see the rollout of a Morningstar family of asset-allocation indexes that goes beyond the retirement date. The Morningstar index family encompasses three groups of indexes—for the aggressive, moderate, and conservative investor profiles—and each includes asset-allocation indexes from 2055 downward in five-year increments to 2000. An additional income allocation applies to people who retired in 1995 or earlier.
However, for now, Delaplane says, the industry lacks a real consensus or definitive metrics for target-date benchmarking. He says, “I perceive among plan sponsors [and advisers] a hunger for better tools.”
*Illustration by Christian Northeast