Target-date funds (TDFs) have seen explosive growth in assets and popularity and are quickly becoming a fundamental part of almost all defined contribution (DC) retirement plans in the United States, according to a report.

Vanguard Investment Counseling and Research’s Evaluating and implementing target-date portfolios: Four key considerations report highlights what plan sponsors should look for when evaluating and implementing TDFs.

Asset allocation glide path.

The large number of available TDFs has led to varying approaches to constructing asset allocation glide paths. Variations exist in the rate of risk exposure decline, in stock/bond/cash allocations, how the glide path will operate once the target date is reached, and in the asset classes being used.

Funds featuring a high exposure to stocks are typically regarded as aggressive, and funds with a higher exposure to bonds and cash are usually considered conservative. However, this may not always be the case, as a fund with a relatively high equity exposure may offset some of this risk with a higher weighting in cash.

“It is important for the asset allocation strategy to maintain a balance between long-term growth potential and risk exposure,” says the report. “Focusing too much on return may subject the portfolio to significant fluctuations in value, while focusing too much on risk may result in inadequate expected returns.

Nontraditional and alternative asset classes and investment strategies are currently being employed to shape the risk/return profile to TDFs. Nontraditional asset classes include REITs, commodities, private equity, and currency. Among the alternative investment strategies are long/short and market-neutral approaches which can offer several important potential advantages compared with investing in traditional stocks, bonds, and cash.

When planning a glide path, the report recommends plan sponsors must decide whether they should systematically decrease equity exposure as human capital diminishes, or if they should be more tactical in nature to capitalize on market fluctuations. The consequences of risk exposure throughout the glide path must be evaluated to determine the level of risk most suitable for plan participants.

Finally, plan sponsors must decide which asset classes are appropriate for inclusion in the TDF solution. If planning to include alternative or non-traditional asset classes, they must understand why they are included, what value they add, and the costs and risks involved.

Passive or active management

Evaluating passive versus active management is a two-step decision process, according to the report. The first step is to evaluate the underlying funds to see which management techniques are employed. TDFs can be all active, all indexed (passive), or a combination of the two.

The second step is to identify whether the funds employ a strategic or tactical asset allocation strategy, each offering their own benefits.

Passively managed funds provide returns that are closely tied to asset-performance benchmarks, making it much easier to explain to a potential client the reasons behind the fund’s returns. If the market is down 10%, so is the fund.

Index funds provide transparent solutions that result in high efficiency and broad diversification, and offer plan sponsors long term, low maintenance investments. This, the report says, should be considered by plan sponsors, who have a duty to employ a prudent process in making investment decisions.

The argument for actively managed funds revolves around a fund’s potential to outperform a market or market segment. If markets are inefficient, there may be opportunities for outperformance, and active management can add value if delivered effectively.

“Plan sponsors who go the active route must decide what combination of risk control and opportunity they want, how confident they are that a manager will outperform and the degree to which they themselves are willing and able to tolerate variability in returns relative to the benchmark,” says the report. “Sponsors should also understand a provider’s justification for choosing one active manager over another.”

Packaged or customized solution

Packaged solutions can be a cost-efficient approach to target-date investing. Owing to economies of scale, fund companies can offer TDFs with relatively low expenses. Larger plans can sometimes customize portfolios at a lower cost than some packaged solutions, but this requires adequate time and resources to implement the approach. The report states that for small plans, costs likely make it impractical to offer customized TDFs.

“With packaged solutions, participants with the same target retirement year get the same portfolio, which means the asset allocation mix and other fund characteristics are the same for everyone at a given point on the glide path,” it says. “Two perceived problems with this structure, however, are, first, that not everyone with the same target date shares the same investment goals and risk tolerance; and second, that participants at one company don’t necessarily share the same demographics as participants at another company.”.

Enter the creation of customized solutions. Customization offers plan sponsors the ability to create an “optimal-solution” TDF, but plan sponsors should first believe that customization will add value. If customization is deemed to be in the best interest of their participants, then consideration of customized portfolios at the individual level may also be warranted. Customizing at the individual level allows participants’ total financial and retirement picture to shape the design of their retirement plan portfolio, leading to a truly individualized investment solution.

Impact on participant portfolios

“When considering the adoption of TDFs, sponsors should understand that their choices will play a critical role in influencing participant adoption rates and portfolio characteristics, according to the report.

It quotes a recent study, The Dynamics of Lifecycle Investing in 401(k) Plans, which finds that the adoption rates of TDFs are at their highest when plan sponsors influence the process and plan-sponsor driven changes were reported to have a much more significant incremental effect on TDF adoption than participant decisions.

“The study further showed that prior availability of a static-allocation fund has the largest influence on whether a participant will adopt a target-maturity fund,” the report says. “In the absence of a static-allocation fund, participants had a 15% probability of investing in a newly introduced target-maturity fund. If a plan had previously offered a static-allocation fund, the probability more than doubled, increasing by 16.9 percentage points.”

The introduction of TDFs on a voluntary basis will also gradually increase adoption rates through new plan entrants and among younger, less affluent, and female participants.

“Ultimately,” says the report “TDFs can produce changes in participant portfolios that are consistent with the objectives of many plan sponsors, including more suitable risk-levels and diversification, which should enhance participants’ prospects for achieving financial security.”

To read the report on Vanguard’s website, click here.

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