Satisfy DOL guidelines with a participant-focused approach to evaluating target date funds.
Wesley Phoa, portfolio manager, target date and fixed-Income funds, 21 years of experience.
Jason Bortz, ERISA attorney, 17 years of experience.
Toni Brown, CFA senior defined contribution specialist, 25 years of experience.
John Doyle, senior defined contribution specialist, 28 years of experience.
Rich Lang, investment specialist, 21 years of experience.
Target date funds have enormous potential to make defined contribution plans more effective and straightforward for participants. But to capture the funds’ benefits — and to help meet fiduciary obligations — plan sponsors must implement thorough, well-documented evaluation procedures.
The U.S. Department of Labor has made it clear that plan sponsors must carefully evaluate target date series before adding them to a plan’s investment lineup, periodically re-evaluate any target date funds currently offered by the plan and document the process.1 Yet evaluating and understanding target date funds can present challenges to plan sponsors. Although the funds are designed to make retirement investing simple and convenient for plan participants, their underlying construction can be complex and can vary widely among the dozens of series on the market.
We believe that plan sponsors’ evaluation process should encompass the following five considerations:
Glide Path Construction
Cost Versus Value
Quality of Underlying Funds
Consistency and Repeatability
In this series of five articles, we walk plan sponsors, consultants and retirement plan advisors through each of the five components of the evaluation process. Thorough, effective target date fund evaluation will help plan sponsors fulfill not only the letter of the fiduciary rules, but also their intent: to give participants the best opportunity to meet their retirement saving and investing needs.
Consideration 1: Participant Needs
Participants face two primary risks:
- Market risk (volatility of returns)
- Longevity risk (threat of outliving savings)
To address longevity risk, target date series seek capital appreciation from stocks and other relatively volatile assets. To address market risk, they seek stability from fixed income and other low-volatility assets.
Target date funds’ challenge is to strike an appropriate balance of appreciation and stability at each point in participants’ careers: one that minimizes longevity risk without exposing participants to unmanageable levels of market risk at any stage. Two types of factors influence the appropriate mix of appreciation and stability:
- Participant age
- Plan-specific characteristics
Participant age is relatively straightforward: Target date series provide high exposure to capital appreciation early in investors’ careers and gradually exchange it for greater stability as investors approach and enter retirement.
Understanding the ways plan-specific characteristics should influence glide path allocations is complex. Many plan sponsors and providers are early in their efforts to gauge which participant characteristics to consider, and to determine the influence on optimal glide path construction. Some factors may suggest a particular direction. For example, participation in an employee stock ownership program (ESOP) may suggest a glide path that emphasizes stability. But a consensus has yet to emerge around the influence of other factors. Some sponsors may conclude, for example, that low average account balances point toward a series that emphasizes capital appreciation, while others may be drawn to a series that emphasizes capital preservation.
Plan sponsors can prepare themselves for this process by putting systems into place to gather and process as much data as they can about:
- Employee age, salary, tenure and account balance
- Employee and employer contribution rates
- Employee eligibility for defined benefit plan
- Typical participant retirement age
- Retirement replacement ratio
- Participation in the plan post-retirement
Collecting these data will give plan sponsors a better foundation for their engagements with consultants and advisors — and will demonstrate to regulators that they are working to fulfill their fiduciary duties.
Ideas for Action
- Conduct a plan information audit to determine what participant data you already have
- Start planning systems to collect the participant data listed above