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Advising Small Plans on Custom Target-Date Funds

Back in 2013, the Department of Labor issued guidelines for retirement plan fiduciaries around implementing customized target-date funds, as opposed to the off-the-shelf variety.

The benefits, according to the DOL, include greater control of the plan’s glide path and selection of investment managers, the inclusion of alternative asset classes and, potentially, lower fees.

Although sponsors had shown interest in custom target-date funds before, interest picked up after the DOL gave the fiduciary guidance, according to Eric Friedman, associate partner with Aon Hewitt Investment Consulting in Chicago.

Mostly Large Plans

Large plans have been the early adopters of customized target-date funds. According to the 2015 Survey of Defined Contribution Viewpoints by Rocaton Investment Advisors LLC and Pensions & Investments, 52 percent of plans with over $5 billion in assets already have a custom target-date fund and another 3 percent are very likely to install one in the next two years. There’s less interest among plans under $500 million though: Only 24 percent have a custom target-date fund and 6 percent report being very likely to offer one.

The $500 million mark has evolved as an approximate measure of when customization makes sense versus what it costs, says Daniel Oldroyd, head of target date strategies, multiasset solutions with J.P. Morgan Asset Management in New York City. That’s because it’s easier to justify customization’s costs over a larger asset base. Fully customized target-date funds must hire a glide-path manager, investment managers and a record keeper to administer the cash. Those are hard-dollar costs, Oldroyd notes, but when they’re spread over $500 million-plus of assets, they fall into the relatively low basis points range. With small plans, the expenses are relatively higher.

Yet Friedman says his firm has some customized plans in the $50 million to $100 million asset range. “Sometimes they implement in a different way,” he explains. “I’ll say the opportunities, the advantages of customization begin to be fairly strong oftentimes around $100 million or so but… even below (that amount) there can be some advantages.”

Considerations for Small Plans

So why would a smaller plan consider customizing their target-date approach? Some believe it will give them a better outcome for their participants or it provides a stronger complement to their defined benefit plan than the off-the-shelf variety of target-date funds. But customization requires time and expertise, and consultants need to be honest with plan sponsors on whether they have enough of either to provide the option while still meeting their fiduciary mandate.

It takes a motivated sponsor to make customization work, notes Oldroyd. “This is something they want to do,” he says. “They believe they have good underlying managers. They believe that customizing the glide path is going to lead to a better outcome. They’re willing to dedicate the time and energy to it. I would note that when you get down in the smaller markets, you tend not to have plan sponsors who dedicate the majority of their time to the retirement plans. (In) smaller organizations, you tend to wear different hats.”

Customization is not necessarily the optimal solution, says John Pickett, senior vice president at CAPTRUST Advisors in Dallas. He reports that none of his clients’ plans has adopted a custom target-date fund although several are large enough to do so. Depending on the counting method, there are between 50 to 100 off-the-shelf target-date funds available, he says. Some of those products will offer a small degree of customization, others will not. Other reasons include costs and fiduciary risk. “You can go get an off-the-shelf target date fund from Vanguard for under 20 basis points,” he points out. “If you’ve got $100 million, the costs come down dramatically. I’ve seen some target-date funds for people with $500 million at under 10 basis points.”

While the fiduciary responsibility for choosing appropriately prudent assets for the plan can be shifted to a 3(38) manager, the sponsor still needs a process for evaluating who those managers are. “When you’re putting your name on it, obviously you’re taking a higher level of fiduciary risk,” Pickett adds.

A Potential Weakness

Consultants should also caution sponsors that external professionals handle some jobs best. Pickett cites a case in which a $1 billion-plus plan considered but did not adopt a fully customized target-date fund. That decision helped the plan stay on track during the 2008-2009 bear market and avoid moving to a more conservative allocation just before the markets recovered. “When I had a meeting with them, a regular quarterly meeting in February 2009, I just asked them anecdotally, if you had gone to a custom target-date fund, would you be considering reducing the risk in your glide path?” Picket recalls. They said yes. “It’s hard to take that human nature out of the decision.”

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