Posted by Jake Adamczyk on June 24, 2013
>>>>> A little over a week ago, we hosted a webinar titled, “The Case for Rethinking TDFs as QDIAs.” The webinar was based on the article by Jake Adamczyk, AIF of the same name that won our 2013 fi360 Article Competition. Mr. Adamczyk was joined by his colleague Mike McKeown of Aurum Advisory Services to discuss some of the problems with TDFs and what fiduciaries should be looking for in a QDIA. A recording of that webinar is now available in the Fiduciary Resource Center. In addition, we had a number of questions that we were unable to get to during the live session and which Mr. Adamczyk and Mr. McKeown were gracious enough to answer for the following Q&A:
Q: As you have observed, underlying TDF holdings run the gamut. Some have commodity exposure; others have none. Is there any move to make underlying fund holdings more uniform?
A: Fund families and plan providers aren’t likely to be champing at the bit for uniformity. After all, product differentiation is a key driver in the marketplace; strictly from a business perspective, fund families pride themselves (and their profits) on their uniqueness. The DOL will not overstep its bounds in so far as dictating how investment management firms should run money. We see nothing wrong with different funds having different holdings, in fact, this is a good thing. If funds had the same holdings, there would be no need to own anything other than an index fund with low expenses.
We would argue that consistency is more imperative than uniformity. Why, for instance, does the equity allocation of 2010 TDFs range from a minimum of 20% to a maximum of 70%? Again, we understand that each fund family sees the world slightly differently; but a 50% difference in equity allocation at the retirement date for a 2010 fund seems a bit excessive. A more consistent approach across like-dated strategies would certainly make it easier for plan sponsors and advisors to evaluate the risks and choose the appropriate fund family given the plan demographics.
Q: Comment on custom QDIAs using the plan's core lineup to build managed allocations and lay a glide path on top of them.
A: We view this type of approach as an intuitive way to provide the same level sophistication to all participants, regardless of whether or not they default into a custom model. In our opinion, it is a fiduciary best practice to offer the same set of “ingredients” to all participants, even within the QDIAs. In our plans, we have found that over 96% of participants choose a model portfolio even if they do not technically default into a model. For our firm, it is a natural extension of our thorough due diligence process to take those same “ingredients” and essentially “bake the cake” for all of the Help Me and Do Nothing investors. Plan sponsors are very receptive to this concept, find it to be simple yet logical, and it has been a key differentiator for us in the marketplace.
As for overlaying a glide path across custom QDIAs, it is not the execution that is difficult for many firms but rather the application of the correct investment thesis. The idea of automatically shifting participants from one QDIA model to the next-most conservative QDIA model as they reach an “age event” is by no means a novel concept. However, the most common error across QDIAs – whether TDFs, balanced funds, or managed accounts – is the failure to correctly match the duration of the assets with the duration of the investor. This may seem to be a simple step, yet companies and advisors continue to err. The main reason the mistake continues to be repeated is plan sponsors and advisors not understanding what drives returns; this would include such things as stress testing the portfolios, measuring downside protection and evaluating holdings and attribution. It gets back to a basic premise of a due diligence process: know what you own and why you own it.
Q: You cited that the average asset allocation to equities to be 38% at the target retirement year and that advisors might not be comfortable with that allocation. Why is that?
The data referred to MarketGlide’s equal-weighted index comprised of the top 30 TDFs – 15 “to” strategies and 15 “through” strategies. The average asset allocation of the top 30 TDFs at the point of retirement is 44% fixed income, 38% equity, 13% cash and 5% TIPS/real estate/commodities.
This allocation is suitable for the average participant, assuming he/she understands other important elements of financial planning such as his/her risk capacity, withdrawal needs, other outside assets, etc. The key takeaway for plan sponsors and advisors relates to evaluating TDFs as QDIAs. We know what the average glide path looks like and what the average allocation is at the point of retirement, but how do your plan’s TDFs compare to the average? More importantly, does the strategy of your plan’s TDFs align with the needs and risk capacity of your participants? These are questions that do not have straightforward answers, and with the DOL increasing its regulatory presence and compliance expectations, these are the types of questions that can trip up the average plan sponsor or advisor if they are not careful.
Q: If you create custom target date funds, how do you benchmark your performance? Though TDFs are not perfect at benchmarking, there is at least data to benchmark. How, as a fiduciary, do you back up your process without having other similar models to compare?
For advisors that create custom QDIA solutions (e.g., managed accounts or collectives), benchmarking can be difficult because of the rigidity of the standardized benchmarks currently available. For example, your moderate allocation fund may not align sufficiently with a 2030 index. Using risk-based benchmarks (e.g., Morningstar’s Moderate Target Risk) for custom models usually provides more tactical flexibility around the respective strategic targets. Understand that benchmarking is not meant to be perfect; cognizant of this, advisors should likewise explain to plan sponsors the ambiguity that is benchmarking.
We understand the need to benchmark model performance; ultimately, it is how each manager is quantitatively judged. Benchmarking is a necessary evil if you are going to run custom models. There are likely to be times of high tracking error and times of low tracking error; it behooves the advisor to proactively discuss with prospective and current clients. We are of the opinion that TDFs are benchmark-dependent, given the fund’s prospectus and asset class restrictions. Ultimately, though, participants shouldn’t be concerned about benchmarks. There are no benchmarks for outliving your money – either you do or you don’t. Until statistics become available that track the success or failure by retirement readiness, we’ll have to work within the status quo.
Q: Why do you think so many plan sponsors use TDF series from one fund company rather than from different companies?
A: In most cases, this is simply a function of the provider/platform. When a plan sponsor decides to hire a provider (e.g. Hancock, Principal, ING), the provider will usually offer its own TDFs as part of the lineup. Many plan sponsors fail to recognize the inherent conflict of interest in this arrangement; there is a monetary incentive for the provider to utilize its proprietary funds rather than offering a competitor’s TDF series. This is just the nature of the business.
This is not to say that proprietary funds are poor investments, but it brings to light an important point for plan sponsors. No matter how they decide to hire a new provider – whether by a word-of-mouth recommendation or a formal RFP process – plan sponsors must have a documented process detailing their due diligence. Because most plan sponsors have neither the time nor the skills to effectively vet prospective providers, this creates ample opportunity for fiduciary advisors like fi360’s AIF® and AIFA® designees.
The industry seems to be shifting from these bundled plan structures of yesteryear to unbundled, open-architecture structures. As the independent advisory channel (i.e. RIAs) gains more traction within the DC space and plan sponsors have a heightened awareness of fees and transparency thanks to 408(b)(2), providers are changing the way they operate. More and more platforms are becoming completely open-architecture, allowing plan sponsors and advisors to choose the best investments for the plan regardless of fund family. We expect this open-architecture trend to continue growing. Emphasis is being placed on improving participant outcomes, and conflict-free investment lineups is a key way to begin this improvement.
We would like to thank Mr. Adamczyk and Mr. McKeown for their participation in the webinar and for making themselves available for this Q&A. Now on to the rest of the best links from the past week.
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