A Primer on Custom Target Date Funds

Source: Hewitt EnnissKnupp

Custom target date funds are a topic that many defined contribution plan sponsors have been asking us about.  The HEK Blog did a short interview with Scott Fisher, who heads our custom target date fund team, to expand on some of the questions that he hears from clients and the things that he observes in his conversations with them. 

HEK Blog (HB): What is a custom target date fund? 

Scott Fisher (SF): A custom target date fund, or CTDF, is a target date fund whose component investment options and asset allocation glide path are designated by a retirement plan sponsor rather than preselected by the vendor of an off-the-shelf product. Typically the investments are drawn from the existing retirement plan menu, but this need not be exclusively the case. The important distinction is that the plan sponsor decides what investments are included, how their allocation changes over time, and the level of the CTDF’s overall expense.

HB: Why do plan sponsors change from traditional target date funds to custom target date funds?

SF: When using a traditional off-the-shelf target date fund product, the plan sponsor can only choose which product, but has no control over the component investments, their expenses, or the product’s allocation glide path. All these decisions are effectively outsourced to the product vendor. In most cases, the underlying funds are all proprietary funds of a single manager (rather than best-in-class managers for each strategy), blend active and passive strategies based on the beliefs of the manager (rather than plan sponsor), and the level of risk in the glide path is designed for a generic plan sponsor (rather than the specific circumstances and views of the plan sponsor). 

Plan sponsors adopt a CTDF approach because they are seeking to leverage their plan stewardship process. In this way, the component funds within the CTDF and the allocation glide path can conform to their view of what is appropriate for their plan and plan participants. When changes are required in the investment menu, they can be consistently reflected in the CTDF. For example, a CTDF might use one active manager for fixed income, a different active manager for small cap equity, and a third manager for passive large cap equity—the same managers that were selected for the core menu.  The investment menu and CTDF are fully in alignment under the auspices of a consistent set of policies, objectives, and overall investment perspective.

HB: What are the drawbacks of customizing target date funds?

SF: There are two main drawbacks to the use of CTDF programs.

First, they require the application of investment expertise in the design of their investment structure and allocation glide path. This expertise is typically present in plans with effective investment committees and staff, often supported by third party investment consultants whose business is to know how to choose and monitor investments. Plan sponsors that do not have good governance structures may have a hard time conducting a sufficiently robust stewardship process to design and deploy CTDFs.

Second, the involvement of additional third party support can involve additional expense. This impact can often be mitigated through the CTDF investment structure construction process whereby these added expenses are offset through the use of lower cost investment options than might be available in an off-the-shelf product.

HB: Are there any myths about custom target date funds that you frequently have to address?

SF: Yes, CTDFs have been around for several years—our first CTDF client started about a decade ago—and there are several myths I often encounter. Here are just a few and the facts that help dispel them:

Myth 1:  Plan sponsors who deploy CTDFs take more fiduciary risk in doing so.

Fact: Some law firms have gone on record as saying that CTDFs do not increase fiduciary risk, and may even reduce it.  By outsourcing the selection of investment components and their allocation glide path, the use of off-the-shelf target date funds prevents the plan sponsor from controlling the component quality, expense, or glide path, but maintains the plan sponsor’s responsibility for these fundamental aspects of the investment program. The use of CTDFs returns the control of these key factors to the plan sponsor, who is ultimately responsible for them either way. We encourage plan sponsors to talk with their legal counsel about issues of fiduciary risk. 

Myth 2: The design and construction of CTDFs is overly burdensome.

Fact: CTDF programs have been in use for well over a decade and the expertise to design, construct, deploy, and maintain them is readily available from a number of industry sources. We typically help plan sponsors design their custom glide paths in two, one hour discussions with their Investment Committees. 

Myth 3: CTDFs complicate a plan sponsor’s communication challenge.

Fact: While communication of the investment aspects of retirement programs remains a key area of focus and effort, the use of a CTDF does not unduly burden this process. In fact, target date funds are typically easier to communicate than individual investment options, once the fundamental aspect of their changing risk profile over time is understood. Participants have shown a ready willingness to use a product that simply asks them when they plan to retire and does the rest of the work for them. The CTDF approach simply improves the ability of the plan sponsor to put a more cost-effective and appropriately constructed tool in the hands of these participants.

Fisher, Scott_Color 

Scott Fisher is an Associate Partner in Hewitt EnnisKnupp’s Investment Consulting group and the head of HEK’s custom target date fund team. 

Disclaimer: The information contained above is intended for general information purposes only and should not be construed as legal or investment advice. Please consult with your independent professional for any such advice.

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