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 4: Quality of Underlying Funds
The funds that underlie a target date series may be as important to its returns and risks as the glide path, so evaluating a target date fund requires an analysis of the funds within it. When evaluating a target date series’ underlying funds, consider the following criteria:
Persistency over long periods. Compare rolling-period returns with those of the funds’ peers. Rolling-period returns eliminate end-point bias — the potentially misleading effect that the end point of a specific time period has on returns for that period.
Plan sponsors can use a number of metrics to factor risk into their analysis. Sharpe ratio measures how well the fund’s shareholders have been compensated for the risk the fund has taken; the higher the Sharpe ratio, the better the fund’s risk-adjusted performance. Comparing upside- and downside-capture ratios also can provide valuable insight into fund results: Look for funds that have captured more of the market’s gains than losses.
Volatility. Reviewing an underlying fund’s volatility metrics alongside those of its peers can provide a sense of the account-balance swings to which it exposes shareholders. Metrics to consider include:
- Standard deviation
- Semi-deviation (volatility of returns below the mean)
- Maximum drawdown
- Worst one-year return
Strategies to mitigate risk. Funds may use a variety of strategies to manage risk. Plan sponsors should be sure to understand these strategies and the provider’s rationale for using them.
Fund consistency. The longer a fund has operated with the same investment strategy, the more confidence a plan sponsor can have that its track record is the result of the strategy rather than fortunate timing. A long history with a consistent investment strategy also gives a plan sponsor the opportunity to review the fund’s performance in a wide variety of economic and market environments, providing greater insight into its likely results in the future.
Tenure of fund managers. Many plan sponsors favor funds with more-experienced managers. Morningstar® notes that more-experienced managers in target date funds generally have produced better results for shareholders, both at the individual fund and series level.2
Diversification. Seek to understand each underlying fund’s approach to diversification. Some funds make it a priority to hold a broadly diversified portfolio; others pursue excess return by concentrating assets in securities or security types the manager believes are attractive. If a series includes funds with concentrated portfolios, plan sponsors should understand and feel comfortable with the role they play in the larger fund series.
Ideas for Action
- Review persistency of underlying funds’ returns
- Examine the consistency of underlying funds’ strategies and management
- Evaluate underlying funds’ approaches to diversification and risk management
2 , Inc, “2014 Target-Date Series Research Paper,” July 2014.