The essential guide to target date funds

[Pages:12]The essential guide to target date funds

What matters most to your plan? DEFINED CONTRIBUTION May 2018

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Not all target date funds are created equal...

More than half of all participants' 401(k) contributions are invested in target date funds1, increasing the importance of a robust evaluation process when making a target date fund selection. Implementation preferences, equity landing points, fees and other factors can significantly affect retirement outcomes. What's more, participants may overreact to excessive volatility and undermine their savings habits. This guide takes a look at some of the critical differences among target date funds to help you make choices that may be right for your plan.

? Cerulli Associates' 2017 U.S. Defined Contribution Distribution Report.

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The first step: know your goals

What do you want for your participants? Do you believe it is important to have less risk exposure (especially nearing retirement) to preserve savings? Or is your goal to help them maximize every dollar invested? The choices you make when choosing a target date fund express your vision, but there can also be unexpected consequences that can undermine your goals.

Different choices, different results

There is a tendency to think about target date funds as investments defined by their target date. In fact, different equity levels at different points in a fund's glidepath can yield dramatic differences, especially under extreme conditions. (See the chart below.) You need to develop an understanding of how key characteristics such as fee structures, asset classes, active or index management strategies, and other factors may impact your participants.

That's the purpose of this essential guide. We will explore some of the available comparisons to help you understand the potential connections between the decisions you make and and the vision you have for participant outcomes.

2015/Retirement vintage return spreads

10% 8 6 4 2 0

1 Year

3 Years

5 Years

Fund A

Fund B

Fund C

Benchmark

10 Years

For illustrative purposes only. Funds may react very differently in various market environments, with wide performance dispersion over some periods, and less dispersion in others.

Annual return

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Setting course for retirement

How does the glidepath impact participants at every career stage?

A participant at 25 years old has very different needs then she will at 45 or 65, and she will be concerned about different risk. Your target date fund has to meet your vision for her at every stage of her career -- and even beyond as she looks to her fund for retirement income.

The target date fund's glidepath maps the mix of asset classes that will bring her from the start of her career into retirement. It sets the equity percentage at the beginning and the landing point at the end -- two of the most significant differences to consider when choosing a target date fund. It sets the rate at which fixed income and inflation-fighting asset classes replace equities as the fund ages to maturity. Your glidepath puts your retirement vision into action and helps shape the participant experience along the way.

Key glidepath decisions

There are three key decisions when building the glidepath: the equity percentage for the longest dated funds, the final equity landing point and the rate at which the equity percentage declines over time. Work with your provider to understand how the glidepath sets out to achieve your plan's objective and what your participants can expect at each stage of their careers.

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Equity allocation

Putting the objective into action

Target date funds need to manage market risk, inflation risk and longevity risk across decades of retirement savings and spending. But different funds take different paths to their target year. Below are glidepath risk levels for three sample funds measured against the category benchmark. Note how the funds reduce their equity allocation as a participant gets closer to retirement.

Same target year, different glidepaths

100 %

80

60

40

20

0

45 40 35 30

25

20

15

10

5

Years until retirement

Fund A

Fund B

Upper/Lower Bounds

Fund C

Fund Benchmark

For illustrative purposes only.

Ret Terminal

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Asset allocation

What's driving the glidepath?

In addition to reducing the overall equity exposure, target date funds seek growth and manage risk through their asset allocation across equity sectors, various fixed income instruments and real assets. Looking beneath the hood to see what's driving the glidepath can help you set return expectations and better understand risk at every age cohort.

Comparing these two sample asset allocations can help to provide you with a better sense of different approaches to diversification. Consider whether the asset allocation aligns with your vision for your participants. Does it drive enough early growth? Is inflation protection a specific part of the allocation?

100% 30

80

60

40

20

Fund series A

0

2055

2050

2045

2040

2035

2030

2025

2020

Ret

100%

80

60

40

20

Fund series benchmark

0

2055

2050

2045

2040

2035

2030

2025

2020

Ret

US large/mid-cap equities

Global real estate

Tips

Other

For illustrative purposes only.

US small-cap equities

US bonds

US HY

Intl equities

US gov

Foreign Cash

Asset allocation

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How does the retirement vintage manage assets?

One of the most important considerations is how the target date fund's retirement assets are invested. How does the fund provider seek to balance the growth needed for potentially decades of retirement savings while protecting against negative surprises? Remember, significant draw-downs in retirement can severely impact participants. You should understand the annualized risk for each choice.

Risk-adjusted return ratio

Annualized return

Annualized risk

Fund A Retirement

Vintage

1.0

4.3%

4.3%

Maximum drawdown

Time to recovery (months)

-4.4% 8

For illustrative purposes only.

Fund B Retirement

Vintage 0.9

4.1%

4.5%

-5.7%

5

Fund C Retirement

Vintage 0.9

4.9%

5.5%

-6.1%

5

Benchmark Retirement

Vintage 0.8

4.2%

4.9%

-6.1%

5

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Taking a close look at performance

Should you seek consistency or total return?

A 25 year old who is auto-enrolled into a target date fund could conceivably be invested throughout her whole career and retirement -- as many as 50, 60 or more years. With that timeframe in mind, it may not make sense to overweight performance differences over a narrow time period.

On the other hand, sustained differences in performance may compound over time, and short-term volatility -- especially near retirement -- can lead to participants making counter-productive changes in their investments or savings plans.

Performance benchmarks

Considering the range of available target date fund objectives and implementations, benchmarking target date performance is difficult. Work with perspective providers to understand their benchmarks -- and you may wish to consider creating a custom benchmark that reflects your objectives.

Performance by asset class

In addition to traditional performance metrics, you may gain interesting insight by comparing risk adjusted returns among fund options and the underlying asset classes. The dispersion of returns for both the funds and the asset classes may help you visualize how the components of a target date fund influence the performance and how they align with your objective. 20%

Annualized return

10

0

-10

-20

0%

2

4

6

8

Annualized risk

Fund A

Fund B

Fund C

Benchmark

Bloomberg Barclays US Aggregate Bond Index

For illustrative purposes only.

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10

12

S&P 500 Index

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