Custom Target Retirement Date: The Optimal Solution?

Target retirement date funds, which essentially embed professional investment advice as an all-in-one investment solution, have become one of the most effective tools to help plan participants choose how to allocate their defined contribution (DC) plan dollars. No other asset class has enjoyed quite the popularity these funds have over the last decade. From 2005 to 2009 alone, assets in the top 15 target retirement date mutual funds have grown by more than 70%, from $69.4 billion to $256.4 billion, according to the March 2010 report, “Morningstar Target Date Series Research Paper: 2010 Industry Survey.” If this growth path continues, by 2015 target date investments will account for 60% of DC plan assets and $1.7 trillion in flows, found the September 2010 McKinsey & Company report, “Winning in the Defined Contribution Market of 2015: New Realities Reshape the Competitive Landscape.”

The acceptance of this multi-asset class solution as one of the most important in a DC plan’s overall investment structure has given rise to a twist on this initial concept — customization. Rather than going with a “pre-packaged solution,” larger DC plan sponsors, typically with plan assets of greater than $500 million, are pursuing custom target date options. With custom target date investments, the glidepath — the asset allocation roadmap — is designed with the investment risk and probability of outcomes based on a plan sponsor’s unique employee demographics and existing retirement benefits structure. In developing the target date asset allocation mix, the sponsor also has the option of mirroring the range of stand-alone investment options available to participants as part of the core fund lineup, or incorporating additional asset classes not otherwise available through the plan.

Although this customized approach may sound enticing, for many plan sponsors the extra resources and fiduciary risk involved in customization may not generate sufficient benefits beyond those of a pre-packaged solution. Customization may involve greater investment and administrative costs and higher fees, which ultimately impact participants’ accumulation for retirement.

Key Elements for Consideration

Before pursuing a custom target date approach, plan sponsors need to determine the specific benefits they might derive versus pre-packaged target date funds. Key elements that need to be considered fall in three main categories:

• Designing and monitoring the glidepath
• Establishing and maintaining target date fund operations
• Paying to implement and maintain the target date funds.

Designing and Monitoring

When creating a custom glidepath, plan sponsors assume additional fiduciary liability for both the selection of investments and also how those investments should be structured, allocated and transitioned over the retirement savings time horizon. As plan fiduciaries, committee members must determine whether, in addition to the oversight of the plan’s core investment options, they also can devote time and energy to create and approve the glidepath.

The decision to adopt a custom approach should stem from a belief that a pre-packaged option is not suitable for the employee demographic. This means that an analysis has been undertaken, profiling the plan population’s unique needs and potential impact. In this process, plan sponsors need to consider:

• How conservative or aggressive the slope of the glidepath should be;
• The suitability of all the underlying asset classes; and
• Asset class implementation by style, strategy and type of vehicle (collective trusts, mutual funds or separate accounts).

The existence of a defined benefit (DB) plan is a particularly critical consideration as it leads some plan sponsors, who may view a DB plan as a fixed-income component of the employee’s overall asset allocation, to take a more aggressive approach to the glidepath. Others may take the opposing view — seeing the DB plan as alleviating pressure on the DC plan as the sole retirement funding vehicle — and so they assume less risk in the glidepath. The presence of a frozen DB plan adds an additional complication as some longer-tenured employees may be covered by the DB plan while newer employees are not.

How the target date option is managed — passive or active — also may be a primary driver of the custom target date strategy. There may be opportunities for alpha generation through a target date option implemented with active managers. However, it will likely require additional time and due diligence to monitor and replace those managers due to changes in the stability of the investment firm or portfolio management team, style consistency, risk level or performance of the underlying funds.

Establishing and Maintaining Operations

Determining how to implement a custom target date option most effectively is an important consideration. Will this be accomplished through a fund-of-funds structure or through a systematic, periodic rebalancing process executed through a plan recordkeeper? If a fund-of-funds approach is selected, which entity will be responsible for the daily computation of each target date portfolio’s unit value and the rebalancing required to maintain each target date’s appropriate asset allocation? Not all recordkeepers have the capability or desire to assume the additional operational risk inherent in this process. If the plan has a bundled recordkeeper/trustee arrangement, it may require an external trustee/custodian to manage this part of a plan’s investment operations. Regardless of the implementation method selected, additional expenses likely will be incurred, which will ultimately affect performance.

Because the goal here is to positively impact participant outcomes by offering an all-in-one investment solution like a target date fund, ease of implementation is critical. How will the funds be communicated to participants so they understand how to use them when selecting from other options available? How will participants be educated so they understand how the target date funds work? Participants have limited patience for complex investment education and not all participants wish to have this education communicated in the same manner. Some participants prefer the Internet while others prefer hard copy. And others may wish to have an individual talk them through the selection process.

Paying to Implement and Maintain

It is critical to review the impact of expense structures on participant accumulation in DC plans (as covered in “Insights into DC Plan Expenses” in the Summer/Fall 2010 issue of Point of View). There may be no greater influence than expenses on outcomes-based vehicles such as target date funds. Depending on a plan sponsor’s philosophy, participants may bear the costs of some or all of the following components. All will be necessary to support a custom target date offering, both at implementation and ongoing:

• Glidepath management
• Fund unitization or model maintenance
• Participant education (fund fact sheets, etc.) and the manner in which it will be communicated.

A custom approach may be optimal for a DC plan sponsor’s employee population, but careful consideration should be given to the all-in cost. If, net of expenses, participants will be positively impacted through excess returns over meaningful periods of time, then the target date solution being considered has passed one of the most crucial validations needed for a custom approach.

Whether customized or pre-packaged, a well-executed target date strategy should enable participants to focus on the more essential elements of DC plan participation: how much they should be accumulating toward a financially secure retirement and how to meet that goal. Plan sponsors who are considering a customized target date approach need to do the upfront analysis to determine if customization is the best way to achieve that objective.

This article is the latest in a Point of View series on issues facing plan sponsors.

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