Target-date or lifecycle funds first came to market in 1994. Since then, they have experienced much growth with nearly every large financial institution today offering their own version of these funds. The enactment of the Pension Protection Act of 2006 (PPA) ignited this explosive growth in target-date funds.
PPA allowed plan sponsors to direct participants’ retirement contributions to a target-date fund if they did not choose otherwise. The Department of Labor (DOL) issued a fiduciary safe harbor for plan sponsors that chose to offer target-date funds to their participants as a default investment option, known as a “qualified default investment alternative.” Plan sponsors were quick to add target-date funds to their 401(k) plan investment line-up and use it as their default investment option.
Along with target-date or lifecycle funds becoming a fundamental investment option of 401(k) plans, comes a fiduciary responsibility to monitor and evaluate target-date funds like the rest of the plan investment line-up. However, plan sponsors may have a tendency to spend less time reviewing their target-date fund series, and instead focus more attention to their core investment options. Target-date funds were not meant to run on autopilot and should be understood by plan sponsors and investment committee members, so they may aptly monitor and evaluate them as part of their fiduciary duty.
To help out plan sponsors and investment committees, the DOL offers tips for ERISA plan fiduciaries with respect to choosing target-date funds, including the establishment of a process for the periodic review of your selected target-date funds. The DOL reminds plan sponsors that plan fiduciaries are required to periodically review the plan’s investment options to ensure that they should continue to be offered.
Target-Date Fund Characteristics
In order to monitor and evaluate your target-date funds, there are key characteristics for plan sponsors and investment committee members to understand. Target-date funds come in all types and kinds, so benchmarking them appropriately requires an understanding of these characteristics, and what makes them unique. A couple of unique target-date fund characteristics are use of a glide-path and a “to retirement” or a “through retirement” approach. The glide path is essentially the shift in the asset allocation over time. The “to” or “through” approach is where that glide path ends, for example to age 65, or through the average life expectancy of someone similarly aged.
Because target-date funds come in all types, investment committees need to be aware of how their funds are composed. Asset classes and the associated asset allocations may vary significantly from one series of target-date funds to another. Asset classes typically include equities, bonds and other investment classes, such as real estate. Within equities or bonds, for example, you might have domestic, foreign and/or emerging market securities within your target-date asset classes.
Also, committees should be aware of the target-date fund investment style, such as active, passive or a mix of those styles. Committees might consider an active style for equities and a passive style for fixed income investments, for example.
No matter what asset classes and investment styles are, this may be accomplished through a customized or a “fund of funds” approach. A fund of funds (most prevalent today) approach may be a pre-packaged product that uses the vendor’s proprietary funds as the component investments, whereas a custom target-date fund series may hold a selection of individual securities and/or mutual funds. So, as a starting point, take a look at your target-date fund holdings to understand how they work and how they are composed. That understanding will help you better evaluate your target-date fund series.
Let’s not forget that your target-date fund fees and investment expenses are a key part of any series review. Target-date fund costs can vary significantly, both in amount and type of fees. Not only should committees understand their series characteristics, they need to learn types and amount of fees associated with their series.
Applying Your Target-Date Fund Knowledge
With a good understanding of your target-date fund characteristics and fees, you can tackle the many questions to ask when reviewing and evaluating the series: Does the series align with our investment policy statement? Are the fees reasonable considering the series investment style? Do we have an appropriate benchmark for our target-date fund series? Is this a reasonable glide path and asset allocation for our participants? Or, should we consider a custom series to incorporate our existing core funds with the target-date funds?
If you have not evaluated your target-date fund series in several years, you need to periodically review this in your committee agenda. The DOL reminds us that plan fiduciaries are required to periodically review the plan’s investment options to ensure that they should continue to be offered. Target-date fund series should be a part of every investment committee review and watch list process much like any other investment option.
For more information on understanding and evaluating target-date fund series contact Larry Ruff at [email protected] or call him at 312.670.7444. Visit ORBA.com to learn more about our Employee Benefit Plans Services.