The Target Date Conundrum

From aiCIO Magazine's September Issue: How much custom is enough?  

To see this article in digital magazine format,click here.

On April 23, 2012, Boeing’s defined contribution (DC) plan ascended to an elevated plane. That spring day, almost $2 billion was transitioned into a custom, open-architecture target-date fund. That fund was years in the making, because customization is complex and time-consuming: It took the combined efforts of Boeing’s substantial in-house investment resources, BlackRock (chosen to provide and implement the glide path), Russell Investments (to consult on the project), and State Street Global Markets (to manage the transition) to will it into being. The result, Boeing officials believe, gives its employees a best-in-class, actively managed default option for an all-in cost of about 45 basis points. 

Boeing is far from the first large and sophisticated plan sponsor to come to the conclusion that its employees were better served by a customized target-date fund. Intel took this path from the outset, and companies like Verizon, American Express, Starbucks, and United Technologies quickly followed—even a handful of 457 plans, notably the city and county of San Francisco, have gone the custom route. Some of these customized target-date funds include esoteric asset classes—TIPS, commodities, real estate, and hedge funds—and tailor-made glide paths. The question that is now being answered is whether more large employers (and, hence, most participants) are going to eschew off-the-shelf target-date funds and go down the custom route. 

This battle, it should be understood from the outset, is the most important struggle now playing itself out in the defined contribution arena, not least because while there are hundreds of thousands of defined contribution plans, almost half of all the assets are in a tiny handful (1% is the common wisdom) of very large plans. And target-date funds, in a remarkably short period of time, are now dominating the defined contribution scene, and for good reasons. For one, they fit hand in glove with the theories of behavioral finance that have swept all before them this past decade. The regulators have blessed them, not least because the evidence of inept investment decision-making by defined contribution participants (either overly aggressive or too cautious—and, whether the former or latter, invariably long on inertia) was there for all to see. Plan sponsors like them, particularly given the safe harbors that accompany them. And, finally, providers, and specifically the large mutual fund complexes that recordkeep most defined contribution plans, very much favor target-date funds, not unexpectedly for self-serving reasons. Target-date funds, full-service providers have discovered, are a handy bulwark against the open-architecture investment architectures that threaten to undermine the economics of their businesses. 

The net result has been an explosion of assets into target-date funds. Vanguard says that 47% of defined contribution participants are now invested in target-date funds, an astonishing number considering the Pension Protection Act, which established the safe harbors that catapulted target-date funds into their present prominence, is barely five years old. Moreover, as many of these participants are part of the “auto” generation (that is, they are being automatically enrolled, or in some cases mapped into these funds), the assets in target-date funds will only grow and grow. It is now accepted as common industry wisdom that most participants going forward will both start and end their workplace savings in target-date funds. UBS Asset Management estimates about $3.7 trillion of a projected $7.7 trillion in DC assets in 2020 will be in target-date funds.

“Target-date funds are where all the action is in DC right now,” says Kristi Mitchem, who heads the defined contribution effort at State Street Global Advisors. “And customization is the trend of the moment.” If Mitchem is right, there is a long way to go. Most of the market share is still in the hands of the target-date mutual fund offerings that captured the initial flood of participant inflows, most notably Fidelity’s Freedom Funds and the Vanguard and T. Rowe Price offerings. The three firms which, according to PLANSPONSOR’s annual defined contribution analysis, between them recordkeep about $1.33 trillion in defined contribution assets—or about a third of the entire US market—rapidly came to understand that target-date funds were key to their future, and all three had notable success in convincing their recordkeeping client base, large and small, to use their respective target-date offerings. Almost all of these off-the-shelf mutual fund offerings had shortcomings, not the least of which was the determination to use proprietary investment products at a time when the defined contribution world was shifting to open architecture. There were other problems, too, particularly with the industry leader, the Freedom Funds, where performance became an issue—particularly as markets collapsed in 2009.

Occupying a middle ground in the target-date wars is a wide swath of second-generation off-the-shelf target-date funds. Solutions range from the defensive (subjected to enough client or advisor indignation, Fidelity will shrink from shoving the Freedom Funds down unwilling clients’ throats, and will offer up indexed alternatives or more open-architecture solutions from its Pyramis division, and even Vanguard and T. Rowe Price now claim they will allow clients to choose any target-date fund they want on plans they recordkeep) to the esoteric. BlackRock, JP Morgan, SSgA, PIMCO, Allianz, and Alliance Bernstein, among others, offer a variety of target-date flavors and architectures.  

The third option is custom. It was initially thought that it was but a matter of time before custom became the rule rather than the exception in the large-plan market. Now it is less than clear that is going to be the case, and only an estimated 20 to 30 corporate plans have thus far chosen the custom path. Still, disciples of the custom route see the issue in stark terms. “Once you get to a certain size, off-the-shelf just makes no sense,” says Drew Carrington, a former Mercer consultant who leads UBS Asset Management’s defined contribution effort. “You have no control over the glide path and no control over underlying asset managers. The equivalent is picking an off-the-shelf LDI strategy for your defined benefit plan: Why would you?”

Carrington’s argument incorporates an interesting equivalency between defined benefit and defined contribution decision-making. Originally, defined contribution was seen as primarily a human relations bailiwick, whereas decisions in the defined-benefit world were driven by finance. That distinction is no more. The type of expertise devoted to, say, choosing a defined benefit asset manager, it was increasingly understood, needed to be mirrored in the defined contribution plan. Some saw in Tussey v. ABB Inc.—a ruling handed down by a federal district court in Missouri in March 2012—an alarming reminder of the plan sponsor’s fiduciary obligations when it came to oversight of defined contribution offerings. ABB (or more specifically the US arm of the Zurich-headquartered power and automation manufacturer), the court decided, had not properly monitored the fees charged by Fidelity, the plan’s recordkeeper: It was the choice of Fidelity’s target-date fund offering and the acceptance of the revenue-sharing fees that Fidelity thereby imposed that was one of two specific instances that the court cited in making its decision.

The Employee Retirement Income Security Act, of course, is more about process than rules, and ABB made some elemental mistakes in documenting its oversight. (For one, it pointedly ignored the findings of its own consulting firm, Mercer, which concluded that Fidelity was overcharging.) But Tussey v. ABB Inc. fits into a larger narrative now increasingly heard in the industry: many plan sponsors acquiesced in their recordkeepers’ proprietary target-date funds when the target-date phenomenon initially came down the pike in the first decade of the new millennium. Now, as target-date funds vacuum up participant share and better fund choices have emerged, different decisions are being made. After all, the target-date choice was of little moment, UBS’s Carrington points out, when its only beneficiaries were new employees being auto-enrolled in the plan. “Now that more and more plans are making the target-date central to their plan architecture, getting the target-date offering right is all-important,” he says.

For those plans that choose the custom path, more than a handful of hard decisions have to be made. The first is selecting a glide path and a glide path manager. Consulting firms will do this for you, some better than others: Russell and Ibbotson are considered the most seasoned providers. BlackRock, JP Morgan, and SSgA would prefer to sell you a target-date solution, but have proved willing under some circumstances to act as a custom glide-path creator and manager, as have Alliance Bernstein and UBS. All of these asset managers want to see their investment capabilities used in the target-date sleeves: If managing the glide path gives them the leverage to achieve that, so much the better. Even consultants seek to use their glide-path capabilities to win mandates that allow them to manage open-architecture target-date funds. 

Glide paths can be adjusted to reflect the demographics of a particular plan, but there is growing skepticism as to the efficacy of this. “You have to be very careful about automatically presuming that every plan is sufficiently different to need its own customized glide path,” says Ann Lester, who runs the target-date solutions group at JP Morgan Asset Management. “Much of what we have learned in these last years is that the real value-added is in the architecture and management of the target-date fund. The glide path matters greatly, of course, but individualized glide paths for plan sponsors matter less than people have been led to believe.” 

Dick Davies, who heads up Russell Investment’s defined contribution initiative, agrees. “I think there is a real case to be made for customization in mega-plans, but I am not sure that glide paths necessarily need to be wildly different at all,” he says. “The key thing is control, and specifically control over the asset manager selection.” 

Once a glide path has been created or chosen, the constituents of the target-date fund—that is the asset management offerings that make up each of the asset classes that underlie the glide path—need to be determined. Most plan sponsors preferring the customized route, regardless of their level of sophistication, choose investment options that are already on the plan menu. From an implementation perspective, most large plans tend to favor a custom fund that is unitized. “In anything approaching $300 million in target-date assets, a unitized rather than a model account solution makes more sense,” says Russell Investment’s Josh Cohen. 

In fact, there are myriad decisions that need to be made, all of which invariably have fiduciary implications. And while it is too early yet to say where the custom wars end, some evidence is accruing that the path chosen by Boeing will prove a bridge too far for most of its peers. Certainly, many large plans now understand that either acquiescing in or being pressured to use their recordkeepers’ proprietary target-date funds is a decision that better be made by commission, if at all. There is also growing acceptance that the latest iterations of target-date funds emerging from the likes of JP Morgan and BlackRock are more intelligently constructed than the first generation of target-date solutions that preceded them. 

Perhaps the middle ground is an off-the-shelf fund, with a bespoke element on the margin—custom, but not really custom. That was the route taken by BP America: the firm is considered a highly sophisticated defined benefit investor, and as the decision was made to implement automatic enrollment in January 2011, the plan carefully dissected the build-or-buy target-date fund decision. The $7 billion-plus plan put out an RFP in 2007 and ended up choosing an off-the-shelf BlackRock solution, which used index funds as its main constituent; about a quarter of the plan’s assets are now, either through participant election or mapping, in the target-date funds. BP trust investment staff say they are thus far comfortable with the BlackRock solution, which costs BP participants about 17 basis points in total. The plan continues to look for enhancements, including the possibility of adding an element of retirement income. “We’ll keep asking BlackRock to incorporate new ideas,” says Candy Khan, who oversees the BP defined contribution plan. 

“The fact is, there is a case to be made for custom target-date funds, but it is only compelling for a very select group of plans,” says Glenn Dial, who runs Allianz’ target date effort. “There are somewhere around the order of 40 target-date series to pick from, and you can probably find one that suits you perfectly. If you’re going to build from scratch, you had better be very confident that your needs are very different and that you know what you’re doing.” 

“At the end of the day, we did felt confident we could build a better mousetrap,” says Julie Nickoley, the director of Boeing’s defined contribution plan. “We could give our participants something better, and at a lesser price. But it was a lot of work, and you have to be staffed robustly to do it.” 

And there’s the rub. Boeing, even in the mega-plan space, is something of an outlier in the resources it has been prepared to bring to bear on its defined contribution and defined benefit plans. There will be plenty of talk still about custom target-date solutions, and the consultants will push customized solutions until their last breath. But the truly powerful players in the space—the likes of BlackRock, JP Morgan, PIMCO, and the revamped Fidelity global asset allocation effort—all seem to be moving in the same direction. They’ll talk custom, but they’ll look to deliver scalable solutions. It was ever thus in asset management: If you want to understand the future, look less at what plan sponsors are interested in buying, and look more at what asset managers are interested in selling.


Note: An earlier version of this article stated that Corning had implemented a customized target-date fund solution in their 401(k) plan. This was incorrect. This version of the article has been altered to reflect this.

Sidebar: Going Alternative 

Intellectually, the case for alternatives in the next generation of target-date funds is unassailable. Selected properly, alternatives are diversifiers and risk-reducers: there is hardly a respectable institutional portfolio in the US without some alternative exposure, whether it is real estate, commodities, private equity, or hedge funds. 

In the defined contribution world, however, there are challenges. First of all, alternatives can sometimes be illiquid, can be difficult to value, and tend to trade on an episodic basis. They can also be expensive and open to precipitous declines in value. For these and other less salutary reasons, only a handful of open-architecture target-date funds have added alternatives to the mix, and even sophisticated plans with real experience of, say, hedge funds—like Boeing—have shrunk from using them. 

That reluctance is unlikely to last, not least because asset managers themselves are looking to differentiate their offerings. Real estate is a natural play, and real estate managers, led by Clarion, REEF, and Prudential, have begun to bring vehicles to the market that would fit into target-date sleeves. “It’s a very obvious fit,” says Doug Dumond, who heads up Clarion’s effort to get real estate exposure into the next generation of target-date funds. “We have resolved the logistical and structural issues and are confident that the fund vehicles we have in place are the right ones. Now it is just a question of choosing the right distribution partners. There can be little question that real exposure can only be additive to a best-in-class target-date fund.” 

Hedge funds pose problems of a different order, but the relatively recent surge in so-called liquid alternatives—and, more specifically, hedge funds or hedge fund-of-funds registered under the Investment Company Act of 1940, i.e. mutual funds—is opening a pathway to the inclusion of hedge funds in the defined contribution space. Few will argue that participants should have direct access to hedge funds, but a much more coherent argument can be made toward their inclusion in a target-date fund, either as an alternative for fixed-income exposure or as a stand-alone asset class. Bridgewater, the Westport, Connecticut-based hedge fund giant, has looked at defined contribution distribution for its All-Weather Fund; AQR, based down the interstate in Greenwich, has already amassed some $10 billion in 1940-Act assets. A handful of more sophisticated retirement-focused RIAs—Raleigh, North Carolina-based CAPTRUST is to the fore here—are looking closely at alternatives for their clients. And groups like La Jolla, California-based Altegris, which delivers hedge fund exposure via fund-of-fund vehicles to the defined contribution marketplace, are also having an impact. 

 For large sophisticated plan sponsors, it is hard to envisage a future that does not include target-date exposure to alternatives—real estate and commodities, for a start. Some of the impetus will come from sponsors themselves, looking to leverage alternative expertise in their defined benefit plans; some will come from target-date providers looking to differentiate their offerings. A lack of transparency and liquidity has clearly dampened the role for alternatives in target-date portfolios thus far, but these challenges are now being resolved by the introduction of new structures and vehicles. What remains is always the most important hurdle in the defined contribution arena: How to get distribution. And that remains unresolved.