Plan Sponsor Perspectives: Target Date Fund Selection and Monitoring

Target date funds (TDFs) are a distinguishing feature of defined contribution plans, with 85% of plan sponsors offering TDFs.¹ These funds automatically increase the allocation to fixed income at defined intervals and become more conservative across the glidepath toward the target retirement year — and sometimes beyond. TDFs are attractive to participants seeking a hands-off approach to investing their retirement savings, as well as to plan sponsors selecting TDFs for the plan’s qualified default investment alternative (QDIA). In fact, of the 80% of plans that have a QDIA, 86% of them use a TDF suite.¹

It is common for participants to invest their entire account balance in a TDF due to the QDIA or the desire to have professional investment management. This increases the importance of a robust TDF selection process by the plan’s investment decision makers and a diligent ongoing monitoring process, both of which are fiduciary duties. In this article, we will share best practices for selecting a TDF suitable for your workforce and for conducting ongoing monitoring.

Regulatory Background

The Department of Labor’s guidance, Target Date Retirement Funds – Tips for ERISA Plan Fiduciaries,
outlines best practices for TDF selection.² Key takeaways from these tips include:

• establish a process for selecting and comparing TDFs and for periodic review;
• understand the TDFs’ underlying investments and the glidepath;
• review the TDFs’ fees and investment expenses;
• take advantage of all available information in the review and decision-making process;
• document the process; and
• develop effective employee communications.

Implicit in this guidance are a few key points to consider. First, as with any investment process, it is important to understand the purpose of the investments, which is to help your unique group of employees invest for retirement. Second, analyze the characteristics of the workforce by collecting workforce demographics, investment behavioral trends — commonly found in reports produced by the recordkeeper — and other workforce data. Finally, establish the plan sponsor’s goals for the plan and overall investment beliefs that will serve as a guide when evaluating various TDFs. Making prudent investment decisions requires these elements to drive the analysis and identify TDFs that are suitable for your workforce. In the next section, we will discuss how these inputs fit into the overall selection process.

A comprehensive and well-documented process is one of the most important components of effective investment management in participant-directed defined contribution plans. With this in mind, we’ve developed a six-step process for identifying and selecting a suitable TDF.

1. Identify philosophy

Philosophy should combine plan goals, employee demographics, and overall investment beliefs. Plan goals might vary from, “We want employees to have a savings and investment vehicle from hire to retire” to “We employ mostly early career individuals with high turnover, so we need a target date fund that recognizes the long time horizon they have until retirement.” Relevant employee demographics to refer to include investor type (e.g., the percent of do-it-yourself investors versus those using TDFs), age distribution, perceived downside risk tolerance and stability of workforce. If your company provides an active defined benefit plan, the lifetime benefits it provides should be considered when evaluating TDFs.

2. Identify desired glidepath shape

TDFs can be as different as the asset managers overseeing them. One difference is the shape and slope of the glidepath. Each TDF manager develops a glidepath based on their view, assumptions made about a generic workforce and capital market assumptions. Many glidepaths are similar at their start with an 85% or higher equity exposure. Glidepaths begin to differentiate in the mid-career years and display the greatest degree of difference during three periods: in the three to five years prior to the target retirement year; at the target retirement year; and, if applicable, after the target retirement year.

As a rule of thumb, higher equity allocations have the potential to increase returns relative to lower equity allocations; however, this is typically at the cost of increasing volatility of returns. Higher volatility of returns is often not a concern for early and mid-career employees who are investing over a long-term horizon as they have many years ahead to recover from market downturns. However, significant stock market downturns in the years close to retirement and after retirement are a concern for participants who will use their defined contribution plan as a primary source of income during retirement.

Another important decision as you begin to explore TDFs is whether a “to” or a “through” retirement glidepath is most suitable for your workforce based on your plan’s pattern of account retention at retirement and after. Plan sponsors who expect employees to withdraw their funds from the plan at retirement might choose a “to retirement” glidepath, whereas those who expect employees to remain in the plan for more than a few years past retirement might choose a “through retirement” glidepath.

It is important to recognize that not all “to retirement" glidepaths are the same and not all “through retirement” glidepaths are the same, as illustrated in the sample glidepaths in Figure 1. The key difference between glidepaths, especially near and at retirement age, is the equity allocation. Each TDF provider has a philosophy about the tradeoff between minimizing volatility and growing the account balance throughout retirement. Plan sponsors should determine the suitable tradeoff for their workforce to identify appropriate TDFs to consider for deeper analysis.

3. Identify initial preferences

It is important for the plan’s investment decision-makers to identify their investment preferences, particularly as it relates to management style and asset class exposure near and after the retirement date. When considering management style, it is important to evaluate preferences, if any, between active, passive and blended strategies. We find that many clients are not able to identify a preference until they see examples of all three. Generally, the active management style provides the opportunity for greater risk mitigation and downside protection (i.e., lower losses during market downturns) but can have higher fees than the blended or passive approaches. Conversely, passive management tends to provide lower-cost market exposure but lacks the same level of risk mitigation and downside protection because the TDF invests solely in index funds.

4. Compare target date funds

By this point in the process, you have identified plan goals, key workforce demographics and preferences regarding the management style and shape of the glidepath. This can help narrow down the universe of TDFs to a more manageable number to evaluate. From here, quantitative and qualitative screening can help to distill a list of investment options that are “best-in-class” within the selected categories.

For example, imagine the process identifies the need for an active TDF series with a “to retirement” glidepath. Within the TDFs that meet those criteria, identify those that have a suitable profile regarding performance, fees, risk metrics and overall operational stability. It is important to remember that a TDF’s performance is often directly related to the equity allocation across the glidepath. Therefore, avoid making TDF selections based solely on performance. TDF performance is often not comparable due to differences in the glidepaths.

In our practice as an investment advisor, we encourage plan sponsors to narrow the field down to no more than 3-4 options, including the incumbent TDF, at this point.

5. Narrow to finalists

Once you identify your finalists, it is time to compare and contrast key differences within investment philosophy, performance, risk metrics and exposure. For quantitative metrics, it is important to use a longer evaluation period (e.g., three to five years). Consider including quantitative metrics such as historical performance relative to the differences in glidepaths, volatility, Sharpe ratio and upside/downside capture. On a qualitative basis, it is important to consider the stability of the TDF’s management team, the level and history of overall assets under management in the TDF strategy and any recent changes to the glidepath and their purpose.

6. Decide and document the process

Once you’ve made a selection, it is important to document the process using the data you collected, the analysis performed and any other key information supporting your decision. These are examples of what may be appropriate to save in the fiduciary file; however, we encourage you to seek guidance from your ERISA counsel. Maintaining a fiduciary file is also helpful for new and existing committee members to understand or recall the process supporting prior decisions.

A full discussion of what factors to review on a regular basis is outside the scope of this article. Instead, we focus on the two types of review: general performance and suitability.

Performance monitoring typically includes a review of returns, risks and fees, among other metrics, against the identified benchmarks and a peer universe. As an example, our Investment Office maintains a proprietary scorecard that measures several key metrics against benchmarks and a peer universe. To pass, a fund needs to score above a designated threshold. If the score is below that threshold for multiple calendar quarters, it will be placed “on watch.” “On watch” indicates that a deeper dive, beyond quantitative measures, will occur to determine whether to retain the fund or replace it.

Suitability, on the other hand, is less about performance and more about fit. Suitability analysis evaluates if the selected TDF continues to be suitable based on goals for the plan, employee demographics and other key inputs. If your organization’s goals or employee demographics change, your organization should consider an ad hoc review of your TDF and overall investment menu. Additionally, you should repeat the TDF suitability review every three to five years. This review should include revisiting the inputs, analyzing the incumbent TDF against two to three of its peers and making the decision to keep the incumbent or execute a change.

TDF selection and monitoring is one of the most important responsibilities of plan sponsors. It is essential that plan sponsors develop a consistent, unbiased approach following the guidance issued by the Department of Labor. PNC Institutional Asset Management® welcomes the opportunity to review your TDF selection and share best practices. For more information, or to schedule a complementary review, please reach out to your PNC representative.