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Five Questions for Picking a Target-Date Fund

August 5, 2008
Related Topics: Retirement/Pensions, Featured Article
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For a 401(k) participant, selecting a target-date fund is simple: Pick the one that ends in the year you plan to stop working and that single fund will take care of all your investment decisions until you retire.

If only choosing target-date funds were that simple for plan sponsors.

The decision to provide these funds to participants is a no-brainer at this point, with about 80 percent of large companies offering target-date options in their 401(k)s, according to Greenwich Associates. But finding the appropriate family of target-date funds can be incredibly complicated for plan sponsors.

No two fund families are alike, and the differences range from subtle to staggering. Target-date funds can invest participants’ assets with an aggressive, modest or conservative approach. Some are passively managed, some are actively managed, and others combine the two approaches. Some carry hefty management fees and others are bargains, while most fees are somewhere in between.

Despite their differences, most target-date funds do have one thing in common—benchmarking their performance is a beast.

Complicating things further, money management companies are rolling out new target-date funds almost every other day, with three times as many funds on the market now as there were just two years ago. With pundits predicting at least half of the $2.5 trillion in 401(k) assets will flow into target-date funds over the next decade, you can’t blame investment managers for wanting in while it’s still early.

Without much history to consider, distinguishing wannabes from winners isn’t easy. Yet plan sponsors had better get it right—especially now that many default participants into target-date funds when they’re automatically enrolled in a 401(k).

That’s where Financial Week comes in. We’ve highlighted a handful of the most important questions to ask when scouting out target-date offerings and bounced them off some of the top observers in the field.

Finding the right target-date funds isn’t easy, but it’s certainly not impossible—especially when you have the answers to these five questions.

1. How do I measure the performance of a target-date fund?
    Benchmarking the performance of a family of target-date funds is a lot like carving a Thanksgiving turkey with a screwdriver. You’ll get bits and pieces of what you want, but you’ll never get exactly what you need to feel satisfied.

There’s a lot to evaluate when you’re shopping for these all-in-one investment options: price, performance, risk profile, asset allocation and the name recognition of the company providing the fund, to name just a few.

But for sponsors, nothing trumps investment performance, says Lori Lucas, head of the defined-contribution practice at consulting firm Callan Associates. "Plan sponsors say performance is the most important criteria for choosing and retaining a target-date retirement fund," she says, pointing to Callan’s survey of large employers in February.

Measuring the performance of a target-date fund is anything but straightforward: Aside from the returns generated by the underlying portfolios, the asset mix will play a big role in a fund’s performance, as will its glide path, as it shifts to income-oriented investments when workers approach retirement age.

Consider this wrinkle: A more aggressive target-date fund—one that invests, say, 90 percent of its assets in equities at the start—will post dramatically different numbers than a more conservative fund that may start at 70 percent equities. When equity markets take a hit, as they did earlier this year, conservative funds will appear to outperform simply because they’re less exposed to equities.

Companies should take advantage of the growing number of benchmarking tools. Dow Jones and TD Analytics have a wide range of indexes that track the performance of funds according to their risk profiles and target retirement dates, and Morningstar is ready to roll out its own set of benchmarks. Lucas says plan sponsors should also ask their investment consultants to create a customized peer-group analysis, so they can see how their funds stack up against the field. Callan expects to introduce one later this year.

"It’s a challenge to really determine the source that’s driving a target-date fund’s performance, but it’s not unfamiliar territory to plan sponsors," Lucas says. "Many have been doing this for years on the defined-benefit side; now there’s just a need to apply similar tools to the defined-contribution fund."

2. How important is a track record?
    Most target-date funds haven’t been on the market very long and don’t have much of a track record, if any, to analyze. There are about 280 of these funds right now, according to data from Lipper, and more than half were launched in the past year.

The lack of a track record can be an issue for plan sponsors, Lucas says, but companies shouldn’t ignore a fund just because it’s in its infancy. "There really is a recognition now that you’re limiting yourself if you don’t consider some of the newer funds."

To get a sense of the performance of newer offerings, sponsors should look at the track records of the underlying funds, she says. "The underlying portfolios usually have some history, so it’s not a totally unknown quantity."

Still, as more companies default 401(k) participants into target-date funds, some argue that it may be in a company’s best interests to consider only funds with a longer history. Jennifer Marconi-Flodin, COO of Chicago consultancy Plan Sponsor Advisors, says she won’t recommend a target-date fund to a client unless the fund has at least a three-year history.

3. How do I know which glide path is right for my plan?
   
Every target-date fund gradually alters its investments over time to take less risk and favor more income-oriented investments, such as bonds, over equities. But each has its own start and end point, and travels along its own glide path—the route it takes to ratchet down risk in time for an investor’s retirement.

"It’s really the story behind a fund," says Pamela Hess, senior retirement consultant at Hewitt Associates. "It’s what makes every fund different, and gives plan sponsors a good sense for what a specific target-date fund is attempting to do for its participants."

The most notable differences tend to occur at the end of a fund’s glide path, when participants are near retirement, she says. Some more conservative funds will allocate up to 75 percent of assets to bonds at that point, to take short-term investment risk off the table and generate a more stable stream of income during a participant’s retirement years. The most aggressive funds could have a bond allocation as low as 50 percent at the end of their glide path, leaving participants with major exposure to equities—which could be risky, but could also provide them with larger nest eggs for several decades of retirement.

Deciding which one is right for your company "really boils down to an employer’s comfort level with a glide path and the overall risk profile a fund may have," Hess says.

But there are some factors to consider. If a company offers both a defined-benefit plan and a 401(k), it can afford to steer participants toward riskier target-date funds because the DB plan already provides workers with a guaranteed income stream during retirement, she says.

4. When it comes to fees, how much is too much?
    It’s not because they’re a bargain that target-date funds have become so popular. Fees on target-date offerings typically have two components: a management charge for the underlying funds and a fee for choosing the asset allocation and doing ongoing monitoring. Add them together and you’ve got a pricey proposition for what is increasingly a default investment, say retirement plan observers.

Even some companies whose target-date funds are made up of offerings from their own shops charge both sets of fees. That strikes observers like Joe Nagengast, principal of Target Date Analytics, as "double dipping."

On average, Target Date Analytics finds that fees run 0.78 percent for institutional share classes, though not all plan sponsors are able to snag this more attractive pricing. Morningstar reports that target-date retail shares charge an average of 1 percent in expenses.

To be sure, there are plenty of offerings that keep fees to a minimum. The early entrants into the target-date universe, T. Rowe Price, Fidelity Investments and Vanguard (together they control 85 percent of target-date assets), have largely stopped levying two fees. As a result, the top three have average fees of 0.54 percent, Nagengast says.

Not surprisingly, Vanguard is the price leader, charging 0.21 percent, on average, for its target-date series. At the other end of the spectrum is SunAmerica 2020 High Watermark C, which charges a whopping 2.3 percent.

5. Should I choose active or passive management?
    Among the many choices plan sponsors must make is active versus passive management. Which is best depends on whom you ask.

"Broadly based market risks make a lot of sense as a starting point," says John Ameriks, head of Vanguard’s investment counseling and research group, a vocal proponent of indexing.

Ron Surz, principal of Target Date Analytics, worries that target-date offerings made up entirely of actively managed funds from a single fund family have little chance of outperforming. "You can’t be expected to be an expert in all asset classes," he says.

"It’s a reasonably good decision to go passive," he says. "You don’t want to muck up your diversification with the vagaries of whether you’ve got a good manager or not."

Not everyone sees it that way. Just 22 percent of target-date assets are managed in a passive style, according to Target Date Analytics’ research. But that may be changing.

Barclays Global Investors, for example, added index funds to its LifePath series in 2005. Other firms, such as Russell Investments, T. Rowe Price and State Street Global Advisors, also mix the two styles.

Fredrik Axsater, head of defined contribution, investment strategy and sales at Barclays, says assets in its indexed target-date funds tripled in 2007, while assets in actively managed products rose 50 percent. Perhaps the views of Ameriks and Surz are catching on.

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