Morningstar’s 2016 Target Date Fund Landscape report shows investors now hold $763 billion in the qualified default alternatives, up from $116 billion 10 years ago.

Last year alone, TDF assets increased $69 billion, in spite of the fact that the Standard and Poor’s 500 Index was down marginally for 2015. For all of the TDF categories tracked by Morningstar, average returns were negative, ranging in losses from 1.2 percent to 2 percent.

There is good news in that data. Morningstar’s report suggests 401(k) TDF investors are maintaining deferral rates when equity markets get shaky.

"Target-date investors have benefited from good behavior,” said Jeff Holt, Morningstar's associate director of multi-asset strategies research.

“While investors in most other broad categories tend to buy high and sell low, target-date investors' pattern of steady contributions and a hands-off approach has allowed them to realize higher returns," he added.

Given their place as the primary qualified default investment alternative, resulting from the 2006 Pension Protection Act, and considering that the majority of 401(k) plans now offer the funds, TDFs are poised for continued growth, Morningstar says.

That reality has consequences for fiduciary sponsors of 401(k) plans and their advisors.

Morningstar’s data shows TDFs are increasingly becoming vital contributors to asset managers’ profits.

T.Rowe Price and American Funds would have experienced net outflows firm-wide had the firms’ target-date series not been sustained by strong inflows.

As asset managers look to capitalize on TDF’s role in the retirement prospects for so many Americans, more products are coming on line. That has resulted in growing product diversity, says the report.

“Target-date series often vary significantly from one another, as managers impart their different philosophical approaches to balancing risks and implementing their asset-allocation decisions, among other factors,” says Morningstar.

The diversity in strategy highlights plan fiduciaries’ growing need to monitor the TDF options they put before participants.

In rating the growing field of TDFs, Morningstar imparts many of the guidelines and tips set forth in a 2013 Department of Labor fact sheet: Target Date Retirement Funds—Tips for ERISA Plan Fiduciaries.

Here is a look at some of the core considerations fiduciaries should be applying in their monitoring of TDFs, as explained by Morningstar’s report.

#1: Pay attention to price.

Fees matter for TDFs, says Morningstar, which says its analysis “has generally found that fees are strong predictors for a fund’s future success. While asset allocation decisions may be the primary driver of results for target-date funds, investors should be attentive to fees because low expense ratios still provide a discernible advantage over higher cost alternatives.”

All TDF strategies deploy an active approach, but some deploy cheaper underlying indexed strategies, which in part accounts for the wide disparity between the cheapest and most expensive funds.

All told, TDFs are getting cheaper. From 2014 to 2015, the average target date series’ asset-weighted expense ratio fell from 78 basis points to 73 basis points.

ERISA is clear that price alone does not satisfy a plan fiduciary’s monitoring responsibilities. In its 2013 fact sheet, here is what the DOL says about price considerations in the context of plan fiduciaries’ monitoring responsibilities.

“TDF costs can vary significantly, both in the amount and types of fees. Small differences in investment fees and costs can have a serious impact on reducing long-term retirement savings. Do you understand the fees and expenses, including any sales loads, for the TDF? If the TDF invests in other funds, did you consider the fees and expenses for both the TDF and the underlying funds? If the expense ratios of the individual component funds are substantially less than the overall TDF, you should ask what services and expenses make up the difference. Added expenses may be for asset allocation, rebalancing and access to special investments that can smooth returns in uncertain markets, and may be worth it, but it is important to ask.”

#2: Expect quality underlying investments.

The DOL says fiduciaries need to go beyond asset class allocation when assessing a TDF’s risk. That means examining a fund’s underlying investments.

Performance track records are one way to assess the quality of a TDF’s underlying investments. But past performance does not purely determine future performance, as fund managers can change, alone with their strategies.

Morningstar rates funds by two metrics—its weighted Morningstar rating, which measures past performance on over three, five and 10 year periods, and its Analysts Ratings scale, which uses a forward-looking approach the incorporates “qualitative factors,” like portfolio manager turnover along with asset allocation strategies, according to Morningstar.

#3: Seek tenure and stability.

Manager turnover can be a red flag for fiduciaries when assessing the quality of TDFs and their underlying investments.

The question of money mangers’ tenure is even more applicable when assessing those more actively managed TDF strategies, says Morningstar.

“Morningstar’s research has shown that longer-tenured managers have generally delivered better returns over the long haul,” the report says.

“Although target-date managers do not typically select individual stocks and bonds, they make a number of decisions that drive results, including setting the asset allocation glide path, selecting underlying managers, and making tactical allocation decisions in some cases. Thus, considering the tenure of target-date managers serves as a good first step in evaluating the people behind the approach.”

In its guidance, the DOL addresses the question of manager tenure this way: “If a TDF’s investment strategy or management team changes significantly, or if the fund’s manager is not effectively carrying out the fund’s stated investment strategy, then it may be necessary to consider replacing the fund.”

Morningstar’s data shows 11 TDF families have manager tenures of more than 10 years, which the analysts said “generally speaks will for the stability and experience” of those managers.

#4: Ask whether TDF managers are eating their own cooking.

After considering fund manager tenure, plan fiduciaries should also ask if those mangers are investing in the products they put before plan participants, a way to signal confidence in their own strategies.

“Morningstar has found that funds with managers who invest alongside shareholders generally have better risk-adjusted records than those with limited or no investment,” the report says.

Morningstar says the target-date space has long suffered low levels of manager ownership, but that the situation is improving.

Ownership data was available for 56 TDF families—29 have no manager investment.

In 2015, 22 fund managers for 14 different target-date series increased their ownership of fund shares. Five managers have invested more than $1 million of their own money in the funds they manage.

#5: Check whether managers are too dependent on a single strategy.

In rating TDFs, Morningstar reviews exposure to underlying strategies to determine the extent of what it calls “single-strategy risk,” or when a series invests a significant portion of assets in one underlying fund. It also assesses “key-man” risk—whether one manager or a team is overseeing an underlying fund. Morningstar says quantitative and team-based management approaches “court less risk.”

In terms of bond allocations, one fund had as much as 28.2 percent of assets in its TDF series allocated to one of its proprietary mutual bond funds, the highest allotment to a single bond strategy.

On the equity side, the same family had 20.6 percent of assets allocated in a proprietary equity mutual fund, the highest allocation to a single equity strategy.

#6: Note how managers balance longevity and market risk.

When monitoring how fund managers balance longevity risk with market risk, fiduciaries should go beyond determining whether a fund takes a more active or passive approach, or whether the strategy is invested to the target date, or through the target date, says Morningstar.

How managers balance longevity risk with market risk is measured in how they allocate equities to bonds along the glide path. Strategies vary widely.

“When target-date managers address one of these risks, they generally assume more of the other,” says Morningstar’s report.

“For instance, a high stake in equities augments a portfolio’s long-term growth potential, but it also leaves it more exposed to a market downturn. Evaluating a series’ strategic equity glide path relative to peers directly gauges its relative balance between these two risks,” the report says.

Equity positions ranged from less than 10 percent to above 55 percent at the target date of retirement for the funds Morningstar analyzed.

#7: Plan fiduciaries should use peer-based rankings carefully.

Evaluating TDF performance is not an easy task for fiduciaries. Morningstar says TDF managers will often refer investors to peer rankings. While Morningstar peer rankings play a role in its own analysis, those rankings can be nuanced, as peer rankings can change “dramatically” from year to year.

For instance, equity-heavy funds benefited in 2014, when the S&P 500 returned 13.7 percent.

“Large changes in rank also typically occur inyears when equities and bonds switch leadership, such as the case in 2008 versus 2009, as well as 2011 versus 2012,” says Morningstar.

Instant Insights /

7 ways plan fiduciaries should monitor target-date funds

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