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Retirement plan target date fund selection process

INSIGHT ARTICLE  | 

The popularity of target date funds (TDFs) continues to grow and is evidenced by strong flows from investors, lifting assets in TDFs to more than $1.6 trillion in 2021, according to Morningstar. In defined contribution retirement plans, TDFs often serve as the default investment option when plan participants fail to make investment  elections for their accounts, or may often act as a “one-and-done” fund for participants approaching their target retirement dates. Given their default role along with their wide diversification and shifting asset allocations, TDFs may serve as a participant’s single investment for many years. This heightens the risk of participant lawsuits on fees and fund performance; these lawsuits have grown in recent years.

Plan sponsors1 must recognize that TDFs represent one of the most critical decisions fiduciaries must make about an investment lineup. While TDFs represent a growing share of retirement plan assets, these investments have varying degrees of volatility2 and are commonly misunderstood. Adding to the confusion are the growing number of TDF options available from which to select. Many of the TDF managers have varying risk glide paths, asset class exposures, underlying investments and active/passive management styles. All of which should be taken into account by plan fiduciaries when selecting a TDF for their retirement plans.

Fiduciary duties under ERISA

Plan fiduciaries must comply with ERISA’s fiduciary obligations in selecting and monitoring target date funds as investment options in retirement plans. ERISA section 404 requires fiduciaries to act solely in the interest of plan participants and beneficiaries to provide plan benefits and to defray the costs of the plan administration. These duties require a fiduciary to act with the care, skill, prudence and diligence that a prudent person acting in like capacity and familiar with such matters would use. In addition, fiduciaries have a fiduciary duty to diversify plan assets to avoid large losses unless it would be imprudent to do so, and to avoid prohibited transactions and conflicts of interest. Plan sponsors act in a fiduciary capacity to the extent that they select and monitor plan investment advisors as the fiduciaries responsible for satisfying these duties. With respect to investments, these fiduciary duties encompass a thorough and independent investigation into TDFs.

Fund evaluation

Given the importance of this unique asset class, fiduciaries must exercise procedural prudence to document proper selection and due diligence. Fiduciaries should establish an objective due diligence3 process for evaluating TDFs. When considering offering target date funds or continuing the use of a TDF series, fiduciaries must consider the relative risks4 and rewards of the TDFs, both as individual funds and the role of such funds in the plan’s total investment portfolio. In addition, plan fiduciaries are required to evaluate all of the plan’s investment fund offerings periodically to ensure they continue to be prudent.

In response to the growing popularity of TDFs and general lack of understanding on the part of fiduciaries, the Department of Labor (DOL) has published some best practices[5] regarding TDF selection and monitoring.

Here are some tips to help plan sponsors build a process for the selection of their TDF that stem from the DOL guidance:

  • Fit analysis – Consider plan investment objectives, plan demographics and participant behavior. Fiduciaries should consider how well the TDF’s characteristics align with the characteristics of a plan’s particular employee demographic. For example, this may include consideration of the plan’s participation rates, salary levels, turnover rates and contribution rates. Other types of retirement plans available to employees covered by the plan should also be factored in, such as a defined benefit or cash balance plan.
  • Qualitative analysis – Understanding the TDF’s underlying investments, management style and tenure, asset class coverage and risk glide path are an important part of the evaluation process. TDF providers often construct TDFs by using underlying investment funds as their foundation. The characteristics of the underlying funds create another layer for plan fiduciaries to evaluate. Plan fiduciaries should look under the hood and have a good understanding of how a TDF is built and how it operates.
  • Quantitative analysis – While broad-based asset class exposure is responsible for the majority of a TDF’s performance, the underlying funds’ performance and fees can be a meaningful contributor or detractor to overall results, and as such, is an important fiduciary consideration. Having a target year in each TDF’s name makes it straightforward in placing each fund into an appropriate peer group to compare results. In selecting plan investment advisors, plan sponsors should look for a process for the periodic review and benchmarking of their TDF performance and fees.
  • Glide path analysis – A TDF’s glide path represents the fund’s changing mix of investments, including stocks, bonds and cash equivalents, over time. When plan participants are further from retirement, the asset mix is more growth-oriented. As the participant’s target retirement date nears, the fund “glides down” to a more conservative mix of investments. However, as depicted in the illustration below, each TDF series has their own specific glide path. The DOL recommends that plan sponsors “understand the fund’s glide path, including when the fund will reach its most conservative asset allocation and whether that will occur at or after the target date.” Otherwise, participants may be surprised to discover that the TDFs geared toward their target retirement dates were actually more risky than they thought.

Target Date Funds Glide Path Analysis

Source: Retirement Plan Advisory Group
 

For example, in a DOL Information Letter issued June 3, 2020, the DOL determined that private equity investments may be offered in a plan as part of a custom target date, target risk or balanced fund. Noting that private equity investments “present additional considerations to participant-directed individual account plans,” the letter indicated that a responsible fiduciary must consider whether:

(i)  Adding a private equity component would offer appropriate expected returns, net of fees or costs, and diversification of risks over a multiyear period

(ii) The asset allocation fund is overseen by plan fiduciaries (using third-party investment experts as necessary) or managed by investment professionals

(iii) The asset allocation fund has addressed the unique characteristics of offering the private equity fund such as cost, complexity, disclosures and liquidity

(iv) The fund’s valuation and liquidity for participants to take benefits and to move them among funds in plan’s investment line-up are consistent with the plan’s terms

(v)  It aligns with the plan’s features and demographics

  • “To” or “through” approach – In the6 DOL Target Date Retirement Funds Tips, the DOL states: It is important to know whether a TDF’s glide path uses a “to retirement” or a “through retirement” approach. A “to” approach reduces the TDF’s equity exposure over time to its most conservative point at the target date. A “through” approach reduces equity exposure through the target date so it does not reach its most conservative point until years later.
  • Sub-asset class analysis – Even though two TDFs may have similar glide paths allowing one to conclude the approaches behind two funds are similar, a closer review in the equity and bond portfolios may reveal differently. Each TDF holds different allocations to each of the sub-asset class categories, including U.S. large-cap equities, U.S. mid/small-cap equities, emerging markets, foreign bond, U.S. high-yield bond and cash. A look at the fund’s prospectus or offering materials will provide information regarding the various asset classes.

The chart below reflects the differences in each series allocations across sub-asset classes. The lines above zero show that ABC Funds holds more of that sub-asset class, while the lines below zero show that XYZ holds more. As illustrated below, the comparison of sub-asset classes captures significant differences.

Sub-asset Class Analysis

Source: Retirement Plan Advisory Group

  • Examine fund fees and investment expenses – Importantly, fees and expenses among TDFs can vary greatly, in both the types and amounts of fees. These differences can have a major impact on a participant’s long-term retirement plan savings, and may even lead to participant law suits alleging excessive fees. Review the fund’s prospectus including sales loads and expense ratios for the underlying funds.

Document the process

Finally, having a TDF evaluation process and understanding your TDF’s glide path will not serve to protect against fiduciary liability unless the decisions made in the fiduciary evaluation and fund selection are documented and supported by plan investment manager periodic reports. This documentation, for example, may take the form of plan investment committee minutes of their internal deliberations, presentations and reports by investment advisors, and procedural prudence in manager selection. Documentation is a key component to assure ERISA fiduciary responsibilities are met and as a defense to any DOL or participant challenges.


1Typically, we don’t want plan sponsors to be fiduciaries for monitoring funds. The only fiduciary function of the plan sponsor should be selecting and monitoring the investment managers who oversee the funds.

2Volatility meaning the amount of uncertainty or risk related to the size of the changes in the fund’s value.  A high volatility means that the fund’s value can be spread out over a larger range of values, and a lower volatility means a fund’s value does not fluctuate dramatically, and tends to be more steady.

3Under case law, fiduciaries don’t have to be right, but they must exercise procedural prudence in carrying out their duties.

4Often expressed as “the risks and rewards” or risk and reward characteristics when talking about investments.

5U.S. Department of Labor, Target Date Retirement Funds: Tips for ERISA Plan Fiduciaries (February, 2013).

6U.S. Department of Labor, Target Date Retirement Funds: Tips for ERISA Plan Fiduciaries (February, 2013).

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