For most plan fiduciaries, the single biggest investment responsibility is selecting and monitoring the target date fund series that is available on their plan’s investment menu.
Since the passage of the Pension Protection Act of 2006 created the concept of a qualified default investment alternative (QDIA), target date funds have become the primary investment option in most defined contribution plans. The funds are used as a default option for participants not making investment elections. They are also used by many participants that do not care to build their own retirement accounts. In many cases, target date funds represent more than half of the total plan assets, and even in cases where they do not represent the largest portion of current plan assets, they are capturing most of the new inflows into the plan.
Unfortunately, many plan fiduciaries have been slow to adapt their committee practices to the changing landscape. They continue to devote significant energy to monitoring the core investment options while spending very little time selecting and monitoring the target date funds available within their plan. It is not uncommon to spend most of a quarterly investment committee meeting talking about the underperformance of the small cap growth fund in the investment menu that has 1% of plan assets, while largely ignoring the target date funds within the plan. Historically, many plan sponsors used the proprietary options of their plan’s recordkeeper. If they chose to use a non-proprietary option, they would look at the cheapest or best performing option.
Selecting and monitoring the target date fund series should be the primary investment responsibility of the plan because of the number of assets invested in the funds within the plan; because of the plan’s unique position as the default investment choice impacts the least sophisticated of your plan’s population; and because the Department of Labor says you should have in place a process to select and monitor your target date funds.
Selecting a target date fund series is a complicated decision because the target date universe is a heterogenous mix of different products. The standardization of the naming conventions for target date funds belies the significant differences that may exist among funds with the same name from different fund families. This is because each investment manager decides their glidepath, which asset classes to include within the glidepath, and how to manage the underlying investment options that are used to implement the asset allocation.
Because of that complexity, we do not believe a prudent process for selecting a target date fund series should be distilled down to using a single variable such as the cheapest funds, those with the best performance, or the proprietary option available from the recordkeeper. Instead, we recommend plan fiduciaries take a thorough, multi-step approach to selecting their target date fund series.
Step 1 – Evaluate Plan Preferences
During the first step, the plan fiduciaries should evaluate their plan preferences to determine which type of target date fund series is the best fit for their circumstances. When we say plan preferences what we mean is the plan-specific information that can guide us to which target date fund series is the best fit for your specific plan. That plan-specific information consists of plan demographic data, plan design features, and a committee’s investment philosophy. These inputs impact the appropriate glidepath, whether you should have a “To” or “Through” glidepath, what types of asset classes should be in the funds and whether the underlying options should be actively managed, indexed, or some combination of the two.
Step 2 – Conduct Investment Due Diligence
Once you understand the plan preferences, you can conduct the investment due diligence to identify good investment series that fit with the plan preferences identified in the first step. While the Department of Labor has created a QDIA safe harbor for plan fiduciaries, it does not absolve you from conducting investment due diligence in choosing a target date fund series. The complexity of these target date fund series requires a different type of investment due diligence than is frequently conducted on other funds within the investment menu. Plan fiduciaries need to consider the resources and capabilities of the investment management firm, the experience and knowledge of the investment professionals managing the funds, their investment philosophy and process, and the capabilities for managing multi-asset class portfolios.
Step 3 – Select a Target Date Fund Series
If a plan fiduciary carefully considers their plan preferences and provides thorough investment due diligence, the universe of target date funds series will narrow considerably. At this point, the plan fiduciaries can consider their options and make a well-reasoned decision to choose the most appropriate target date fund series for their plan. While this process may seem daunting, an organized committee working with a fiduciary advisor can get it done.
For more information about selecting and monitoring target date fund series, please register for our May 24 webinar on the topic.