Evaluating target-date funds through the prism of the DOL fiduciary rule

Like all investment strategies, financial advisers are now evaluating target-date funds through the lens of the Department of Labor’s new fiduciary standard. Advisers often assume they are meeting their new fiduciary obligations by simply recommending the lowest cost option. However, this new regulatory environment calls for a more holistic evaluation process to ensure the best interest of retirement savers.
Advisers can’t solely rely on fees to evaluate target-date funds, but must conduct a multifaceted due diligence process that goes beyond the active/passive decision. In fact, the notion of a purely passive target-date fund is a fallacy. Even passive providers must make a series of active decisions.
The glide path design is a critical aspect to consider when selecting a target-date fund, as it is the primary determinant of risk and return and is a proprietary decision made by each investment manager. As a result, even passive target-date funds exhibit wide dispersions in their equity allocations and, subsequently, their returns. For example, since 2008, deviations in calendar year returns between the 2020 vintage of five major passive target-date fund series have been as high as 741 basis points.
The key to evaluating a glide path is assessing whether it is appropriate for a plan’s participants. Are participants able and willing to accept more risk in their portfolios to seek greater returns? Or is wealth protection of utmost concern leading into retirement?
Another crucial factor to keep in mind is whether the target-date fund provides sufficient asset class diversification. Passive target-date managers tend to offer less granularity in asset class exposures, as certain fixed income and alternative asset classes can be difficult and/or costly to replicate passively. It’s also important to understand whether the manager has a strategic approach to asset allocation, changing the asset class mix fairly infrequently, or has flexibility to make short-term tactical moves to respond to changing market environments.
Finally, evaluating the underlying fund options within target-date funds requires the adviser to consider not only active/passive or blend, but also open versus closed architecture. Are the target date’s underlying funds managed by just one investment firm or are they diversified across various investment managers throughout the industry? The plan’s approach regarding its menus of standalone investment options should help guide what target-date approach is most appropriate for the plan.

(Related read: To be a fiduciary, invest like one)

Using a broader set of criteria to evaluate target-date funds empowers advisers to deliver insights more aligned with the investment objectives of their clients and ultimately help lead to better retirement outcomes. Most agree that this is the ultimate goal of the DOL’s new fiduciary standard.

THE FUTURE FOR TARGET-DATE FUNDS

As the industry continues to adjust to the new DOL fiduciary standard, we believe open architecture TDF strategies will continue to gain favor for the following reasons:
Access to top managers: Flexibility to add and replace managers over time, since many due diligence factors — firm issues, turnover, etc. — can impact a manager’s ability to outperform in different market conditions.
Diversification across managers: The benefits of diversification extend beyond asset classes to include diversification across the investment managers.
Reduction of single manager risk: This is afforded by a broad roster of managers with low alpha correlation and differentiated investment processes.
Overcome capacity constraints: Closed architecture strategies are particularly vulnerable to such capacity issues, as they may have no other investment options when an underlying strategy grows too large.
Addition of new asset classes: Closed architecture target date strategies are unlikely to have exposure to all asset classes, especially in some of those more specialized areas.

(Related read: FAQs: The most comprehensive fiduciary database)

An open-architecture approach is considered to be best-practice in the DC and DB industry and will be a key part of the evolution of the target-date strategies in the new regulatory environment. By incorporating the best investment managers throughout the industry, target-date managers are giving investors the opportunity for additional excess returns, improved diversification and, ultimately, the potential for better retirement outcomes.

Weber Hsu is a portfolio specialist for multi-asset strategies and solutions at Voya Investment Management.

Related Topics: Retirement Watch