Tips on How to Carefully Evaluate Target-Date Funds

Given the fact that Sway Research projects that more than half of all retirement plan assets will be invested in target-date funds (TDFs) by 2025, it is more critical than ever that retirement plan advisers and sponsors carefully evaluate TDFs in their lineup, says Brendan McCarthy, head of defined contribution investment only (DCIO) national sales at Nuveen.

“We are seeing a huge focus on the QDIA [qualified default investment alternative], with advisers employing the three R’s,” McCarthy says. “The first is to reevaluate the TDF. The second is to replace it if it is found to not be appropriate, and the third is reenrollment, which is a great way to get a plan back on track in terms of where participant allocations should be.”

In addition, as exposed following the Great Recession of 2008, “there is an alarming amount of variation in risk composition from one target-date fund manager to the next,” Newport Group writes in a white paper, titled, “A Prudent Approach to Evaluating Target Date Funds.” “We believe that prudent selection of a target-date manager must consider many factors beyond the basic intention of the strategy.”

ERISApedia.com has published an extensive 401(k) Target-Date Fund Market Share Study, which among other key findings argues there exists a “fair amount of correlation between market share and the quality of a target-date fund vis-à-vis its peers in the target-date category as measured by an industry-recognized fund scorecard.”

When SEI Institutional works with its individual or plan sponsor clients to help them select a TDF, it first focuses on risk tolerance, says the firm’s director of defined contribution investment strategies, Jake Tshudy. “Whether the selection is being done for an individual or a whole corporation, understanding their risk profile is fundamental,” he says. “When working with an individual, you also want to look at what other savings they may have and other sources of income, and have them fill out a risk tolerance questionnaire. When working with an organization, we look at participant data and want to understand a company’s total benefit package. We look at when participants expect to retire, how much Social Security they are likely to receive, and from there, create projections to determine the risk level for the cohort.”

SEI also asks plan sponsors if they want participants to remain in the funds post-retirement, which then leads to a discussion of whether they want a “to retirement” or “through retirement” TDF, Tshudy says.

This selection should guide advisers and sponsors on how to evaluate a TDF’s glide path, according to Newport Group’s paper. “Some managers will choose the conservative path and dial down equity exposure early,” the firm says. “Other managers will consider the risk of underfunding and outliving retirement assets and will maintain an aggressive posture in their portfolios for years after retirement.”

At this point, it is important to evaluate a TDF’s performance, McCarthy says, pointing out that both Lipper and Morningstar have three-, five- and 10-year performance data on TDFs. “It is important to look at these figures because these are longer-term investments that need to deliver over various market environments,” he says.

Besides the quantitative analysis of performance, there are qualitative factors to consider, according to Newport Group, most important of which is the diversification of the underlying holdings in the TDF. “Is there sufficient diversification across asset classes and sub asset classes?” Newport Group queries. “Are nontraditional an dlower correlated asset classes such as REITs [real estate investment trusts], emerging markets, global bonds and high yield bonds included?

“The next perspective to consider is a breakdown of the strategies by asset class,” Newport Group continues. “We feel that, at a minimum, a portfolio needs exposure to the basic asset classes: large cap value and growth, mid and small cap value and growth, international equities, aggregate bonds, global bonds and a passively managed component.”

It is also important to find out if the manager permits tactical asset allocation in response to changes in the economic outlook and market volatility, Newport Group says. “We believe a modest allowance for tactical management is acceptable,” the firm says.

While many TDF series employ a closed architecture, SEI believes that open architecture, where the manager seeks the best in class, is preferable, Tshudy says. “We need different managers, strategies and asset classes,” he says. “Diversification should be happening on all levels.”

And when evaluating the funds in the fund-of-funds TDF, it is also important to figure out if there is “substantial overlap in investment styles and objectives,” Newport Group says.

It is also important to look at the experience of the fund manager, McCarthy says. He recommends selecting TDFs with a manager who has at least 10 years of experience.

Finally, Newport Group says other questions to ask are “is the fund’s annual expense ratio at or below the median for its peer group? Are the expenses reasonable given the investment strategy, i.e. active versus passive, tactical asset allocation versus strategic?”

For its part, Newport Group evaluates its clients’ TDFs every quarter, “to ensure the series continues to meet the standards of a plan fiduciary. In addition, we include quarterly commentary that highlights any changes made to the management team or process, asset allocation, or underlying strategies over the course of the quarter.”