Tuesday, December 30, 2008

Advisers can do much with 'set it and forget it' investment options

Employee Benefit Adviser

By Michael Kaplan

November 1, 2008

... Much has been written about how the proliferation of fund options in DC plans leads to "analysis paralysis," in which participants are overwhelmed by the number of choices and choose not to participate in the 401(k) plan at all - or make an inefficient allocation, such as putting all their assets in one fund option.

By offering lifecycle funds, plan sponsors can make it easier for participants to select an appropriate portfolio that optimizes their risk/return preferences.

Four main decisions

Plan sponsors have four main decisions to make in choosing lifecycle funds for their DC plans ...: target-date versus target-risk funds; customized way of using the plan's core funds versus an off-the-shelf product; actively managed versus indexed underlying strategies; a fund with or without a tactical asset allocation component.

Target-date funds typically link each investment portfolio to an expected retirement date, with the asset allocation adjusted periodically to reduce investment risk and protect assets for the retirement years. Target-age funds operate similarly, but instead of focusing on a selected retirement date, the asset allocation changes in tandem with the participant's age.

Target-risk funds (categorized as conservative, moderate or aggressive) maintain a specific asset allocation to provide an even exposure to investment risk.

With target-risk funds, participants typically need to initiate transfers to more conservative funds as they approach retirement. But with target-date funds, the shift to a more conservative allocation is accomplished systematically by the investment manager. A potential problem with target-date funds is that participants may place too much emphasis on the date in the fund's name when deciding their selection. ...

Depending on a participant's circumstances (such as investment assets outside the plan, spending habits or the value of their home relative to the mortgage), a more aggressive or less aggressive fund may be a better fit. ...

Meanwhile, there is increased interest in custom lifecycle funds. A sponsor's custom lifecycle fund uses a combination of the core funds, ensuring the same group of funds is offered to all participants. ...

A customized approach provides the opportunity to include higher-risk and alternative asset classes in a lifecycle vehicle. This can be more appropriate than having these asset classes as a stand alone option, and their risk can be minimized, since the lifecycle vehicle will be highly diversified.

Advisers should help sponsors consider the additional costs associated with creating and managing a custom lifecycle-funds program, compared to an off-the-shelf product. Plans of sufficient size construct their lifecycle funds using separate and commingled accounts, rather than mutual funds. The use of these vehicles may offset some or all of these costs through lower investment management fees. ...

There's also the issue of fiduciary risk in a custom program, since the plan sponsor needs to develop the asset allocation and roll-down strategies (resetting the target asset allocation over time by shifting assets out of stocks and into bonds and cash), thus opening the door for criticism if they turn out to be unsuccessful.

Where creating custom lifecycle funds is desired, but not practical, some plan sponsors are turning to indexed or passive off-the-shelf lifecycle funds. ...

... Participants who prefer lifecycle investing may prefer indexed strategies. Lifecycle investors seek to minimize their active involvement.

With index funds, there is minimal risk of style drift or underperformance due to active management decisions. On the other hand, there are disadvantages to indexed lifecycle funds. Participants choosing these funds do not benefit from active management, which can outperform passive investing. Fund expenses ensure passive lifecycle funds will always underperform their benchmark on a net-of-fee basis.

Obtaining exposures to classes that offer diversification benefits but are not easily indexed, such as real estate or infrastructure, may be difficult.

Lifecycle funds may strictly adhere to or tactically deviate from their asset allocation targets, based on the manager's market outlook. Tactical shifts are usually enacted within a narrow range. ... Managers want to avoid the risk of underperforming due to poor tactical decisions. However, a manager with strong tactical asset allocation capabilities can add value while maintaining an allocation close to the strategic targets for each target year. ...

Kaplan leads Mercer's DC investment consulting business in the U.S. Northeast region. He can be reached at

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