Best Practices by liaoqinmei


									Best Practices:

Target Date Fund Selection and Monitoring for
Retirement Plan Fiduciaries

Wes Schantz, ChFC
Jim Edwards, AIF
David Will, AIF
Shannon DiValerio, MBA

JUNE 2009

Target Date Funds (TDFs) continue to serve an instrumental role within defined contribution
(DC) plans. Because the Pension Protection Act of 2006 (PPA) approved TDFs as a Qualified
Default Investment Alternative (QDIA), many DC plans now offer TDFs as the primary default
alternative. Because each fund family may have different investment management processes,
philosophies, asset allocations (glide paths), portfolio structures, and investment alternatives
(active vs. passive), TDFs are challenging to monitor.

Important Disclosures

Investments in securities involve risks, including the possible loss of principal. When redeemed,
shares may be worth more or less than their original value.

This material is intended for informational purposes only and should not be construed as legal or
tax advice and is not intended to replace the advice of a qualified attorney, tax advisor, or plan


For a variety of reasons – including participant requests for advice, legislative support for
automatic programs in DC plans, and the shifting of investment risk to participants as DC plans
become more prevalent – TDFs have grown in popularity in recent years. Accordingly, many
plan sponsors need a better understanding of the differences among fund family product
offerings and their associated risks and rewards. Plan sponsors and investment committees that
fail to perform a thorough scrutiny of the marketplace merely because the selected plan provider
offers only proprietary target date options may be putting themselves at significant fiduciary risk.
Whether the result of active participant choice or of no choice at all (i.e., a negative election
situation), we have observed that new participant contributions to DC plans are directed more to
TDFs than to many other investment options. This trend highlights the need for extra due
diligence when fiduciaries evaluate the best option for the participant base.

Important Characteristics of Investment Portfolios

One of the foremost differences among TDF families is the construction of the “glide path”,
which represents the asset allocation strategy among stocks, bonds, cash, and alternatives
throughout the investment life of a participant. As indicated in Exhibit 1, this asset allocation
strategy varies widely among TDF families. In most cases, modern portfolio theory (MPT) and
numerous asset allocation studies (e.g., Brinson, Hood, and Beebower, Determinants of Portfolio
Performance, The Financial Analysts Journal, July/August 1986) inform this proprietary
decision to allocate more or less to equities at any given time in an investor’s life. Such studies
generally state that 90% or more of an investment return is determined by asset allocation while
the remainder is based on market timing and security selection. In light of this significant
emphasis on asset allocation, a plan fiduciary must evaluate whether a TDF family and its glide
path methodology match the needs of the average plan participant.

Evolution of Target Date Funds

Since 1994, the number of TDF providers has grown from approximately five major providers to
more than 70. Morningstar has reported that as of January 31, 2009, total asset growth in TDFs
has reached approximately $156 billion. The Profit Sharing/401(k) Council of America has
determined that about one out of every three plan sponsors offers TDFs in its plans. According
to Hewitt & Associates, about 45% of plan participants who have TDFs available to them use
one of the funds in the series. In light of the newly-established PPA safe harbor guidelines,
many plan sponsors have established TDFs as the QDIA for both newly-eligible participants and
existing participants who have not made prior investment elections. As both plan sponsors and
participants seek user-friendly, risk-adjusted, and diversified investment options for retirement
savings, it is likely that TDF usage will continue to increase.

Not All Target Date Fund Families are Created Equal

The evaluation of a TDF should be based on factors including, but not limited to, the following:
asset allocation, active vs. passive management, proprietary vs. non-proprietary fund selection,
expense ratios, and series increment. A critical differentiator among TDFs is the “glide path”,
which represents the allocation between equities and non-equities at various times during the
investment life of a participant. As indicated in Exhibit 1, all TDFs have a high equity exposure
at the beginning of the glide path, when a participant is farthest away from retirement and can
assume greater investment risk. As the target date approaches, all TDFs steadily decrease equity
exposure. It is important to note that some TDFs carry significantly higher exposure to equity
throughout its glide path and especially different equity exposures during the income or
retirement years. While higher equity exposure can lead to good relative returns in up markets,
they may expose participants to greater potential for loss in down markets.

Exhibit 1

                                                          Glide Path




             0.600                                                                                            Fund Family A
                                                                                                              Fund Family B
  % Equity

                                                                                                              Fund Family C
                                                                                                              Fund Family D
                                                                                                              Fund Family E

             0.400                                                                                            Fund Family F
                                                                                                              Fund Family G
                                                                                                              Fund Family H
             0.300                                                                                            Fund Family I



                     2055   2050   2045   2040   2035   2030       2025   2020   2015   2010   2005   Today

                                                         Target Date

Source: Morningstar 2/28/2009.

Understanding the Risks

In light of these differences in glide path methodologies, there may be substantial variations
among the series of a fund family. As shown by trailing one-, three- and five-year returns
through December 31, 2007, these variations might not seem as evident during an up market.
However, during a period of market volatility and a continued down market, the variations
among returns may be alarming. We compared the historical returns from several TDF providers
with established track records of at least five years. Exhibit 2 indicates the performance of a
sample of fund families during a representative upturn in the markets for the two years ending
August 31, 2007 (i.e., fund up-capture experience). Exhibit 3 indicates the performance of the
same sample during the recent market downturn from September 10, 2007 through February 28,
2009 (i.e., fund down-capture experience). Both Exhibits reflect the cumulative, not annual,
returns of each family’s most conservative income product.

Exhibit 2

                         Cumulative Upside Performance from 9/1/2005-8/31/2007




    15.00                                     12.83                                                    13.00
                                    11.67                          11.88             12.02
                10.97                                                       10.36              9.71




Source: Morningstar 2/28/2009.

Exhibit 3

                  Cumulative Downside Performance from 9/10/2007-2/28/2009




     -15.00     -14.32              -13.94

     -20.00                                                                                           -18.91



Source: Morningstar 2/28/2009.

As shown in Exhibits 1, 2, and 3, fund families that offer aggressive glide paths with more
equities allocated throughout the lifetime of a participant (Exhibit 1) have generally performed
well when the equity markets are expanding (Exhibit 2). However, they generally perform worse
during contracting equity markets (Exhibit 3). These results are in line with expectations.

Why do the Differences Exist in Fund Family Methodologies?

As stated previously, all glide paths start with a significant portion of assets allocated to equities.
As the target date approaches, all glide paths slowly decrease exposure to equities and increase
exposure to fixed income or cash. However, throughout the glide path, the extent of equity
exposure differs among fund families. In the early years of the glide path, equity exposure is in
the narrow range of 85% to 90%. However, in the later years of the glide path, equity exposure
ranges from 15% to 60%. This difference in equity exposure in the later years depends on the
philosophy of the particular fund family. Fund families that emphasize capital preservation will
dedicate less to equity in the later years. Other fund families address longevity risk – the risk of
outliving one’s assets – by dedicating more assets to equities with the goal of continuing to grow
assets and fight inflation into the retirement or “drawdown” years. We believe that a 15% equity
exposure is reasonable when addressing inflation risk. (Note that some of these more
conservative families will also use inflation-protected bonds as well.) Families that have a
greater equity exposure (above 30%) are focused more on longevity risk than on capital

Active Management vs. Passive Management

A TDF’s portfolio structure is populated by funds that are either actively managed or passively
managed. Whether active management, with its higher expenses, can consistently outperform
over the long term an index fund with lower expenses has been hotly debated for years. Rather
than argue the merits of one management style over another, we believe that it is more important
to consider the type of investor who will normally be drawn to a TDF. A participant may either
actively choose a TDF or be automatically defaulted to one. Reasons that a participant would
actively choose a TDF include the lack of time for proper investment research, the lack of
investment expertise, and the desire to leave the investment and periodic rebalancing decisions
up to a professional manager. Participants who are automatically defaulted generally avoid
making investment decisions and often have moderate to high levels of risk aversion. While
active management does offer the potential for outperformance in any given period, there is at
least the same chance that it will underperform a benchmark. (In fact, some would say that in
light of the higher expense structure of active management, the potential to underperform
exceeds 50%.) With indexing strategies, the TDF will expose participants to the broad markets
and perform in line with the equity and fixed income markets. Some TDFs offer a blend of
active and passive styles, using passive management in more efficient markets and active
management in less efficient ones. We believe that a proper blend of active and passive
strategies is ideal for a TDF.

Proprietary vs. Non-Proprietary Fund Selection

In today’s market, most TDF families are populated with proprietary underlying funds. For
example, the Fidelity Freedom Funds are comprised solely of Fidelity Funds. For many large
mutual fund families, this may be of little concern since offerings in the major asset classes that
make up the TDF are adequate. Other TDFs offer options that include mutual funds from
different fund families (e.g., a bond fund from PIMCO, a large-cap blend fund from American
Funds, and a small-cap value fund from T. Rowe Price). Since most of the performance of a
TDF is based on its asset allocation, both strategies may be effective long-term solutions.

Expense Structure

Because expense ratios among TDF fund families vary widely (as shown in Exhibit 4 below),
fiduciaries should carefully consider expenses when evaluating these options. All else equal, a
TDF family with lower expenses will outperform a family with higher ones. To provide plan
sponsors and recordkeepers with options as they consider the overall pricing of a plan, most TDF
families offer a number of share classes with different expense structures and revenue-sharing
arrangements. While expenses should not be the sole factor considered in the evaluation of TDF
options, they should also not be ignored.

Exhibit 4

                                 Targe Date Expense Ratios - Family Averages
     1.00                                                                           0.91

                                             0.85              0.85

     0.80                                                                                  0.72
                0.69        0.68
                                                    0.67              0.67








Source: Morningstar 2/28/2009.

Series Increment

TDF providers provide funds with either five- or ten-year increments (i.e., number of years
between target dates). The difference between a participant’s actual target date and the TDF’s
target date will likely be smaller if a TDF with five-year increments is selected. That said, there
are several qualitative factors to consider if a participant’s target date should fall between fund
target dates. Accordingly, if all other factors seem to fit the participant base, a ten-year
increment should not eliminate a fund family from consideration. A high-quality education
campaign should be able to overcome the ten-year increment issue fairly easily.

Performance Benchmarking

When evaluating and comparing TDFs, plan sponsors and investment committees need to be
careful. Because many TDFs do not have long-term performance histories, it may be difficult to
perform thorough and meaningful analyses. Even with information from independent research
firms such as Morningstar and Lipper Analytics, which provide access to data for peer analysis
and benchmarking purposes, benchmarking TDFs against one another may still be a challenge
because of the many differences in equity allocations, management styles, and other factors.

Many firms do offer proprietary benchmarks that compare their series’ performance to a custom
index with a similar asset allocation. However, this information would apply only to that firm’s
specific TDF allocation strategy and not to other TDFs with different allocation strategies.

The Dow Jones US Target Date Indices, published by Morningstar, is based on the methodology
used by the Dow Jones TDFs. However, since this methodology is very different from that of
the majority of peers, this information is of limited usefulness.

In March 2009, Morningstar began to provide target date benchmarks for TDFs with five-year
increments and conservative, moderate, or aggressive glide paths. Each series includes 13
benchmarks ranging from Income to 2055. To date, this seems to be the most useful information
available to the general population. What these benchmarks fail to reflect, however, is that most
TDFs have a similar equity exposure at the beginning of the glide path. The allocation
differences among series become significant as the target date approaches. Therefore, it may be
necessary to customize the Morningstar benchmarks to better reflect where a particular TDF falls
on the glide path. For example, the aggressive benchmark may be suitable for the 2050 offering
while the conservative benchmark should be used for the 2010 offering.

While the benchmark offerings have improved, we believe hurdles still remain for each.

Fiduciary Risk - Selection

The selection of the appropriate target date series should be based on the actual participant
demographics of the plan. We do not claim that one size fits all plans; however, our research and
experience have demonstrated that a more conservative philosophy, especially in the later years
of the glide path, may be suitable for most plan populations. As indicated in Exhibit 1, the
differences in equity exposure are least pronounced at the beginning of most glide paths,
generally averaging around 90%. Consequently, for most families the upside potential is similar
during the early years, when accumulation is important and risk exposure is less of a concern.
The use of a more conservative philosophy, however, will result in moving more assets to fixed
income investments over time, which in turn will provide the potential for greater protection on
the downside throughout retirement. While longevity risk is indeed a concern and growing
assets even while in retirement is a noble cause, we believe – in light of last year’s negative
equity returns – that excess equity exposure is too significant a risk for participants to assume at
that stage of their lives. (Refer to Exhibit 3 for an illustration of downside experience.) We
hope, of course, that we will never experience another 12-month period in which equities lose
40% of their value; however, there is no guarantee that this will not happen again. Therefore,
downside protection – in addition to upside performance – during the years approaching and
after the target date is important to consider when evaluating TDFs.

The most likely candidates to use a TDF are those who are not engaged in the investment process
and who will readily admit that they lack the expertise to properly navigate the other investments
in the plan. By nature, even though they know that saving for retirement is important, they are
weary of making investment decisions. Risk aversion and downside protection appeal greatly to
these participants. Accordingly, plan sponsors should pay particular attention to downside
performance when selecting a TDF strategy as their QDIA.

That said, for some situations a more aggressive glide path may be appropriate. Such situations
include: 1) a participant base with high incomes that has a larger percentage of total retirement
assets outside the company plan; 2) a co-existing defined benefit plan that provides significant
income replacement ratios at retirement and that is expected to continue; and 3) a co-existing
post-retirement benefit plan that is expected to continue. Under these scenarios, participants may
be able to assume more risk with their DC plan, even into retirement.

Fiduciary Risk - Monitoring

Fiduciaries may be at risk not only during the initial selection process for TDFs, but also while
monitoring them. Most Investment Policy Statements (IPSs) indicate that a fund should
outperform some benchmark as well as rank above the respective peer group average. However,
such peer rankings for TDFs do not reflect the differences in asset allocation at any point on a
glide path. Further, as stated above, obtaining an objective benchmark may be a challenge.
While Morningstar has significantly improved the peer rankings by narrowing its peer groupings

from 15-year increments to five-year increments, comparing peers that have different asset
allocations remains an issue.

Given that having a documented, consistent, and repeatable process is recommended for the
ongoing monitoring and analysis of all plan investments, how do fiduciaries overcome this
hurdle of benchmarking and mitigate the fiduciary risk? One solution could be to modify the IPS
to reflect a new method to monitor the target date options. Another solution could involve an
improved way to benchmark TDFs. Some methodologies we are considering include grouping
peers by asset allocation, standard deviation, and peer age group. (Best Practices: A New
Philosophy for Benchmarking Target Date Funds is forthcoming.)

The monitoring of the TDF selection within the plan should emphasize manager tenure. Most
IPSs indicate that a manager should be in place for at least three years. A manager change could
and should trigger a watch list status while further evaluation of the new manager is conducted.
With TDFs, there are two types of managers to consider. The named manager on the TDF
strategy is responsible for the strategic implementation of the asset allocation and glide path
strategy, but generally not for actual security selection. If this manager changes, we believe it
necessary to move a fund to watch list status until confidence is restored that no change in
strategic direction will occur and that effective implementation of the glide path strategy will not
be interrupted. Since most TDF strategies use a “fund of funds” approach, a change in one or
more of the managers of the underlying funds, which may have an effect on the overall look of
the TDF, could also trigger a watch list status. Although more difficult, we believe that a best
practice during the due diligence process would be to consider manager changes on the
underlying strategies.

Other Considerations

It is also important to evaluate the industry’s plan providers and recordkeepers. Nearly all
providers boast of open architecture investing, yet for TDFs, the options tend to be extremely
limited. While due diligence should always be performed when selecting any investment option,
we believe that as TDFs become more prevalent in plans, they could become a source of legal
scrutiny. A plan sponsor that employs a recordkeeper that offers only one TDF family will not
necessarily be at risk as long as that TDF family is reasonably suitable for the participant base.
However, if due diligence indicates that there may be better target date solutions available in the
marketplace but not at the current vendor, the plan sponsor does have options. For example, the
plan sponsor may request that the vendor increase its offerings, as vendors are often willing to
act on such requests. Even so, other vendors may be unwilling to expand their offerings since
the target date offering is a significant revenue source. If continuing with a current TDF family
puts the fiduciary at significant risk, the last resort would be to test the market for a vendor
(which in any case should be done every three to five years as a best practice). A consistent due
diligence process should be completed to ensure that all offerings reasonably fit the plan’s

participant base. As long as a consistent process has been followed, fiduciaries should feel
confident that risk in this area has been minimized.


TDFs offer both plan sponsors and participants an effective investment vehicle for retirement
savings. Plan sponsors should be aware of the inherent risks and rewards associated with TDFs
and cognizant of the differences among TDF series. Many plan sponsors select the target date
series that is proprietary to their provider; however, these selections may not be in the best
interest of plan participants and may put the plan fiduciaries at significant risk. Many providers
now offer the ability to choose from an open architecture, which will enable plan sponsors to
best match a particular TDF to their participant demographics. To minimize fiduciary risk, it is
most important to follow a consistent due diligence process both during the initial selection as
well as for ongoing monitoring of all investment options in the plan.


MFP is a member firm of M Financial Group, one of the nation's premier financial service
organizations comprising of more than 100 firms that oversee in excess of $50 billion in client
assets. As an independent registered investment advisory (RIA) firm, MFP provides fee-based
consulting and investment advisory services to qualified retirement plans, corporations,
institutions and private clients.

For retirement plan sponsors, our services include negotiating reductions in plan fees and
expenses, co-fiduciary to the investment selection and monitoring process, formalizing and
documenting fiduciary roles and responsibilities, monitoring and benchmarking plan service
providers, keeping clients informed of compliance updates, plan trends, plan design changes, and
educational considerations that encourage plan participation and investment diversification. In
addition, MFP helps companies develop, implement and informally fund nonqualified executive
retirement programs to recruit, retain, reward, and retire top performers.

 Jim Edwards, AIF                                 Shannon DiValerio, MBA
 Partner                                          Senior Retirement Plan Consultant         

 Wes Schantz, ChFC                                David Will, AIF
 Partner                                          Senior Investment Consultant         

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