DC Insights

The right benchmark Measuring target date fund success

Consultants and plan sponsors appear divided on the issue of the most appropriate way to measure success when selecting a series of target date funds. To date, the focus of many defined contribution decision-makers has been on comparing a target date funds returns to those of a passive benchmark an imperfect approach, as it does not account for the investment managers asset mix decisions, which will likely have a significant affect on returns over time.
A company making a contribution to a defined contribution plan, or automatically enrolling an employee in a 401(k) plan may find itself without investment instructions from the participant. Plan sponsors can remedy this situation while still receiving 404(c) safe harbor protection under ERISA by investing those monies in an appropriate Qualified Default Investment Alternative, of which target date funds are a popular option. A plan sponsors obligation to select its QDIAs remains an important fiduciary duty, and, as such, benchmarking target date fund results is a critical part of looking after the interests of a plans participants. The two most commonly used benchmark approaches are index-relative and absolute return. Each of these approaches has unique advantages and drawbacks when used with target date funds.

Index-relative benchmarks
Plan sponsors and consultants are very comfortable benchmarking an investment managers results to a published index such as the Standard & Poors 500 Composite Index or the MSCI World Index. Furthermore, custom benchmarks can also be created from published indexes. For example, the results of a number of investment managers may be compared to a custom benchmark that rolls up the asset class approaches and respective weightings of each portfolio manager to determine the value added across a plans overall assets. While this approach only tells part of the story, it is not without merit, since it does highlight the difference a good manager can make excess returns can add up to a significantly larger retirement base over time. A drawback to using index-relative benchmarks with a target date fund series is that they make no allowance for the managers asset allocation decisions. This is a major shortcoming because a target date funds success will in part be dependent on asset allocation, and glidepaths vary considerably among managers. As such, an index-relative approach could lead plan sponsors and consultants to select target date funds that fare well against their chosen benchmarks returns but substantially underperform other target date funds. In figure 1, for
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example, Active Manager A beats the benchmark by a larger amount than Active Manager B. Active Manager B, however, has been more successful in growing participant assets, and this would not have been measured by an index-relative benchmark. From a participants perspective, index-relative benchmark comparisons on their own are of little value since asset accumulation and income sufficiency are their primary goals. In light of these observations, it is important for plan sponsors and consultants to choose target date fund benchmarks that measure success from a participants point of view. Therefore, index-relative benchmarks may not be the best choice for evaluating target date funds.

Benchmarking alternatives
Absolute return benchmarks

Absolute return benchmarks provide an alternative way to measure a target date funds success. One example of this type of benchmark involves establishing a minimum acceptable return often the Consumer Price Index plus a return premium. Minimum acceptable return benchmarks provide an excellent way to measure a funds success in providing inflation-adjusted income for retirement. Participants with long investment horizons (say, 2040 and after) need returns that significantly outpace inflation. For them, a return of CPI plus 600 basis points might be an appropriate minimum return goal in their long-dated funds. Retiree portfolios, on the other hand, need to reduce volatility while still maintaining some growth. For this group, CPI plus 350 basis points may be a more realistic minimum return goal. Minimum acceptable return benchmarks such as these provide an excellent way to measure a funds success in ways that are meaningful to plan participants.
Naive indexes

Cumulative results

Another benchmarking option is to establish a naive index that is based on a general view of what constitutes an appropriate asset allocation for a particular target maturity series. For example, a naive index composed of 60% MSCI World Index and 40% Lehman Figure 1: MeasurinG only ManaGer skill Can be MisleadinG Brothers Aggregate Bond Index could be used to compare all 2015 target maturity rB manage Active funds. This approach allows plan sponsors Manager and consultants to evaluate results in the skill context of general market conditions, and ad index Bro is particularly useful during difficult rior glidepath) (Supe market environments in which absolute Superior glidepath not returns are low. The broad nature of a nager A Active ma measured by naive index also allows a managers asset relative-index mix decisions to be evaluated as well. approach
Manager skill

Narrow index (Inferior glidepath)

A limitation of both the absolute index and the naive index approaches, however, is that they are somewhat subjective e.g., a minimum acceptable return or the composition of the naive index must be determined before any fund comparisons can be made.

Time

Peer groups

Comparisons of funds with similar target dates are another way to gauge a funds performance. Some defined contribution decision-makers are reluctant, however, to use them because asset allocations can vary considerably across target date funds. This concern is understandable, particularly if a plan sponsor or consultant believes that performance comparisons are meaningful only when like funds are compared. Once the goals and viewpoints of participants are considered, though, peer group comparisons make tremendous sense. Target date investors need to maximize the growth of their retirement assets within tolerable thresholds of risk, and fund-to-fund performance comparisons among similarly dated target funds allow participants to see which have been most successful in growing retirement assets. The fact that one target date fund included asset classes that another did not is of little importance to the target date fund investor. It is important to note that all of these benchmark approaches have limitations. Significant differences in asset class returns over short periods of time can make one managers results look better than they may really be over the long haul. In addition, none of the benchmarks discussed above account for volatility. If a participant is unwilling or unable to remain invested during adverse market conditions, the long-term return potential of an aggressive target maturity fund is irrelevant. Finally, the lack of longer-term historical return data for target date funds further complicates choosing the series of target date funds that would best serve the interests of plan participants. We believe that absolute return, naive and peer group benchmarks are better than index-relative benchmarks when evaluating success from a participants perspective, but all target date benchmarks have limitations.

Benchmarks should evaluate the success of participants

Benchmarks are tools used to measure investment success. Funds with similar target dates should be benchmarked so that success can be compared in ways that are meaningful to participants. Index-relative benchmarks cannot properly measure the value a fund adds through its asset mix decisions, which will likely have a significant effect on whether the fund can create sufficient assets for retirement. Other benchmarks, including absolute return benchmarks, are better aligned with the interests of plan participants. Good peer comparisons are not yet available because meaningful long-term results across target date fund managers are not currently available, but these will be valuable comparisons in ten years time. Equity glidepath differences are important to consider, particularly in the years leading up to and right after retirement, but plan sponsors and consultants should not be misled by the false precision of a funds modeling assumptions or data. Capital market assumptions and participant behavior assumptions do not foretell the future. n

The statements expressed herein are informed opinion, speak only to the stated period, and are subject to change, at any time, based on market or other conditions. This publication is intended merely to highlight issues, and not to be comprehensive or to provide advice. 2007 Capital Guardian Trust Company www.capitalguardian.com/definedcontribution

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DC Insights

Collective trusts A cost-effective alternative to mutual funds

One decision defined contribution plan sponsors face is choosing the right investment vehicle. Mutual funds have historically been the most common choice, thanks in part to name recognition and the perception that they are easier to use. Collective trusts, or commingled funds as they are often called, are gaining in popularity, however. This is mainly due to two reasons: they have a competitive fee structure and they have become as easy to use as mutual funds. Collective trusts have long been the pooled fund of choice for corporate and private defined benefit plans because they are designed for institutional investing and are typically the low-cost option once economies of scale are factored in.

Competitive and flexible fees

Fees can make a significant difference in a participants accumulation of retirement assets. With DC plan fees under growing scrutiny, costs and transparency are increasingly important to plan sponsors, consultants and recordkeepers. While there are certainly exceptions, fees for collective trusts are typically 30% 50% cheaper than mutual fund fees, according to a recent study by Hewitt Associates.1 Furthermore, plan sponsors with multiple defined contribution and defined benefit plans can usually aggregate assets to qualify for fee discounts from their investment managers. Collective trusts are overseen by federal and state banking authorities. Compared to mutual funds, collective trusts typically do not have expenses from independent boards, SEC and state filings and fees, and Sarbanes-Oxley requirements. Collective trusts also provide flexibility, as most offer multiple pricing options. Fees can either be reflected in the daily net asset value or billed outside the fund. Another option is to reflect the administrative fees in the daily NAV and charge management fees outside the fund. In each case, these can be offered with or without recordkeeper pass-through fee options, which keeps recordkeeper costs transparent and outside the expense ratio.

Ease of use
Less than 10 years ago, the notion that collective trusts were cumbersome for DC plans had merit. Today, technology has enabled collective trusts to emulate some of the best operational features of mutual funds so that they can work seamlessly on recordkeeper platforms, making it easier for plan sponsors to pass any cost benefit on to participants.
1

Hewitt 2005 Survey, Trends and Experiences in 401(k) Plans

Collective trusts designed for DC plans are valued daily and employ fair value pricing just like mutual funds. They can also be assigned a CUSIP and traded daily through the National Securities Clearing Corporation (NSCC), which began including collective trusts in 2000. Similar to mutual funds, many collective trusts now have all-inclusive service agreements with major recordkeepers, which streamlines the process of setting up a fund for use in a retirement plan. In many ways, collective trusts can be thought of as private mutual funds, with the added ability to customize fund names for the plan. According to Hewitt Associates, an estimated one-third of collective trust assets are stable value funds1, so many plan sponsors with a stable value offering may already have some experience using a collective trust.

Visibility
The large mutual fund families still have the advantage of name recognition among participants. Hand in hand with that familiarity is the ability of participants to track their fund in the newspaper. Technology, however, is making that less relevant. Participants in collective trusts can access information on their funds, including daily NAVs, through websites provided by recordkeepers and plan sponsors. That information is also available through databases such as Morningstar Direct and eVestment Alliance.

Focus
Commingled funds typically have tighter investment guidelines and invest based on a specific objective, making the plan sponsors asset allocation decisions more straightforward. Mutual funds may include several asset classes and security types within their funds and generally maintain a higher level of cash, therefore adding a layer of complexity. Additionally, mutual funds are designed to accommodate diverse pools of investors and therefore tax planning may be inherent in the management of the fund. Collective trusts are tax-exempt retirement pools that require Figure 1: MORE SIMILARITIES THAN DIFFERENCES no tax planning and management to balance portfolio transactions, and have Commingled funds Mutual funds no annual capital gains or ordinary income distribution requirements.

Daily valuation Low fees Fee aggregation Flexible pricing options NSCC trading Recordkeeper pass-through options Fair value pricing NAV online Brand recognition NAV in newspaper

Brand recognition Newspaper access

Another option: separately managed accounts

Large plan sponsors may also opt for separately managed accounts, which have their own advantages, including a cost advantage over most mutual funds. Another benefit is that a separately managed accounts investment policy and guidelines can be tailored to the plans needs, giving the plan sponsor greater control over how the assets are invested. This is especially helpful to sponsors that want their investments to reflect their views on social issues. Separate accounts are less vulnerable to trading abuses, since they are not open to outside investors. Plans can also earn income if they choose to participate in a securities lending program. Some of the features that collective trusts share with mutual funds, however, are not available with separately managed accounts. Separate accounts need to be reunitized for daily valuation, they are not traded through the NSCC, and there are no opportunities to achieve economies of scale by sharing third-party costs such as custodian fees. A few technical aspects make a separately managed account somewhat more cumbersome than a collective trust. A collective trust has a legal framework in place to manage withdrawals and contributions during potential crisis periods and has credit lines available to cover large withdrawals that cannot be anticipated. A separately managed account, on the other hand, will need its own cash management guidelines, sponsor-arranged liquidity backup, and cash buffers, and usually has a smaller pool of assets to draw on. Separately managed portfolios also need to establish dedicated accounts to hold local securities in various markets. Furthermore, in a collective trust the investment manager is the ERISA fiduciary and takes responsibility for disclosing the nature of the potential investments and the risks involved to participants, whereas the plan sponsor takes on this responsibility with a separately managed account.
Figure 2: MEDIAN EXPENSE RATIO BY CATEGORY Retail mutual funds Intermediate-term bond Large Value Large Growth Small Value Small Growth International 0.55% 0.85% 0.93% 1.12% 1.20% 1.05% Commingled funds 0.30% 0.55% 0.56% 0.96% 0.94% 0.80% Separate accounts 0.30% 0.51% 0.52% 0.92% 0.90% 0.75%

Three viable options

Plan sponsors have more options today now that collective trusts have become easier to use. Collective trusts generally have lower fees than mutual funds, leading to more prevalent usage in DC plans. Separately managed accounts can also play a role where a tailored solution is required. Mutual funds continue to be appropriate for some situations, but for most plan sponsors they are no longer the automatic choice. n

Mandate size: intermediate bond, international and small-cap value and growth $25 million. Large Cap $50 million. Source: Hewitt Associates

The statements expressed herein are informed opinion, speak only to the stated period, and are subject to change, at any time, based on market or other conditions. This publication is intended merely to highlight issues, and not to be comprehensive or to provide advice. 2007 Capital Guardian Trust Company www.capitalguardian.com/definedcontribution

The Capital Group Companies Capital International Capital Guardian

Capital Research and Management

Capital Bank and Trust

American Funds