Josh Cohen is the head of institutional defined contribution for Russell Investments. He is a member of the Department of Labor’s ERISA Advisory Council, and actively involved with the Defined Contribution Institutional Investment Association and the Employee Benefit Research Institute. He recently shared his insights on retirement plan investment issues with EBA.
EBA: What changes have you seen recently in what plan sponsors are looking for in a target-date fund series?
Cohen: Sponsors have been looking to move away from the historical approach of filling up lineups with name-brand single-manager funds, which are oftentimes proprietary funds for the recordkeeper. They’re looking to move to a more institutional approach of white label funds, open architecture, multimanager solutions.
EBA: That would take a lot of work …
Cohen: So many plan sponsors don’t have the time, resources or scale or expertise to do that efficiently, so they’re looking for outsourcing partners to take on the discretionary role to implement such solutions. Also, sponsors are looking for support in selecting and monitoring vendors, like the recordkeeper’s support in delivering participant communication efforts.
EBA: Could a plan sponsor’s decision to stick to a basic off-the-shelf target date fund series, in theory at least, be a fiduciary breach?
Cohen: Every case will have its own facts and circumstances. But in general, most litigation involves allegations that sponsors did not meet their fiduciary obligation to ensure that their investments that they offered in plan were appropriately reviewed and monitored, based on prudent investor standards, and that fees were not benchmarked and determined to be reasonable for the value of the services provided. In 2013 the Department of Labor’s tip sheet on target-date fund selection recommended that sponsors “inquire whether a custom or nonproprietary target-date fund would be a better fit for your plan.” So I would think plan sponsors would be well-served by documenting their rationale for deciding to – or not to – use a proprietary fund.
EBA: Is there a plan size threshold for a proprietary target-date fund solution to be economically viable from the sponsor’s perspective?
Cohen: Like many things, it depends. Historically, custom target-date funds were implemented for larger plans with targeted assets starting around $200 million; scale was needed given certain costs such as unitization of the funds and custom glide path design. But today there are more customized solutions being rolled out to smaller plans. For those that don’t want to go to a fully customized approach, there are many off-the-shelf funds that provide many of the same benefits of a custom solution, particularly ones that are open architecture and well diversified across asset classes.
EBA: Do the Department of Labor’s regulations allowing target-date funds to be a QDIA [qualified default investment alternative] constrain what can be done to customize them?
Cohen: There’s really not a limitation. The definition is just a portfolio where the allocation is based on age. The QDIA regs require any target-date fund, whether custom or off-the-shelf, to have a mix of capital preservation and growth assets. And all that means is you can’t have 100% of a target-date fund in equities or other growth assets. The TDF regulations do specifically address custom solutions; what they say, though, is that they need to be managed either by a registered investment adviser, or the plan sponsor.
EBA: Are customized TDFs inherently more costly to operate than an off-the-shelf one, and if so is that an issue for sponsors?
Cohen: I would caution sponsors about making very simple fee comparisons on an absolute basis. You need to make sure that you are looking at the value of the solutions, and that you’re making apples-to-apples comparisons. So you can always find a cheap target-date fund on an absolute basis, but that fund may be all passive, the glide path may not be a good fit for your participants, and it may not be very well diversified from an asset class perspective.
Furher, it may be a target-date fund that is composed entirely of the proprietary funds of that manager. Such solutions may not be in the best interest of participants, because it may not help them meet their retirement income goals. Typically a custom target-date fund provides a very good value to participants relative to a comparable type of approach because it provides best-of-breed managers, a smart mix of active/passive, you typically get exposure to diversified asset classes and you get a customized glide path. And often also you can leverage the buying power of the sponsor.
EBN: Since most employers don’t have a workforce with uniform demographics – for example, some will wind up earning a lot more than others over the course of their career – what are the general principles that dictate how you customize a target-date fund?
Cohen: There many ways to deal with this. Typically we recommend that the glide path be designed for the group that is most dependent on the 401(k) plan to meet the retirement income goals, and to make sure it works well for the rest. But other factors come into play, such as actual savings rates. This is why I strongly believe that target-date funds need to evolve to one that is customized, not just at the plan level, but at the participant level.
EBA: How do you do that?
Cohen: There could be different ways to implement but we have a solution on the marketplace, we call it “adaptive retirement account.” It uses technology to pool specific individual characteristics from the plan’s recordkeeping and HR systems, and to, based on that, implement a customized allocation for each individual based on their specific situation. Our methodology is all about having a participant have a high likelihood of meeting their retirement income goals. And we look at an individual’s personal funded ratio, so how likely are they to meet those goals.
EBA: What principles typically dictate the use of passive versus actively managed funds for the constituents of a TDF?
Cohen: We definitely would advocate for a mix of both, and plan sponsors do have some varying views, and different fee and risk budgets. But while we believe active management has a role in most asset classes, typically we see greater use of passive management in areas like developed market equities, both U.S. and non-U.S. We see active more in fixed income, in particular core bonds, high-yield and emerging markets debt. In equities, we see more active management in small cap and global and emerging markets.
EBA: What is your approach to using alternative asset classes?
Cohen: In both our off-the-shelf and our custom solutions, we believe in real assets, particularly things like REITs, commodities, and listed infrastructure, and especially fixed income such as high-yield and emerging market debts. You don’t always see that as much in many off-the-shelf solutions. In addition, some of our custom clients incorporate nontraditional and less liquid asset classes, including private, non-traded real estate, and hedge funds.
EBA: Do your clients’ allocation to alternatives tend rise and fall given market conditions in traditional investments?
Cohen: It depends on what asset classes and the role they play. Some are more growth allocation, some of them more on capital preservation, and most kind of fall somewhere in the middle. Those are diversifiers and don’t necessarily provide as much return as equities, but tend to be diversified and maybe not as much risk, even when they fall somewhere between equities and fixed income. But it depends on the specific asset class.
EBA: Have your long-term return projections for a typical balanced portfolio changed in recent years?
Cohen: We’re obviously going to hit in a historically low interest rate environment, which lowers the expected return on all asset classes. So what this means is it will be more challenging for participants to meet their retirement income goals. We have been making adjustments for our strategic allocation, both the level of risk in the portfolios and how we diversify across multiple sources of returns. So even though the portfolio is going to have to work harder, we can’t just take undue risks, so participants may need to pull other levers as well, including saving more, retiring later, and maybe even reducing their expectations.
EBA: Is it difficult for plan sponsors to assess the performance of a customized TDF?
Cohen: Many sponsors and their advisers take a long time in selecting a target-date solution, and they do it based on their particular objectives for the plan, the characteristics of the plan, and strategic investment beliefs on how to construct a portfolio. But then what I observe is a year or two later, the target-date fund performance is often compared to just a myriad of other random target-date fund solutions that may have been built with different objectives and strategic beliefs in mind.
So while it’s important to be aware of how other solutions are performing, I don’t think you want to over-emphasize such results, particularly over a short period of time. Instead, you want to evaluate the solution based on your specific objectives and identified criteria for success. And the reality is it takes multiple dimensions in evaluating how well it’s doing, and first and foremost is how much it’s helping participants meet their retirement income goals.
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