Custom Target Date Funds Differentiate Your Retirement Plan Business

Target date funds (TDFs) have surpassed $1 trillion in assets in recent years, with custom versions of these products increasingly used by defined contribution plans. As you review investment menus with retirement plan clients, consider recommending custom TDFs for greater flexibility, control and alignment with the needs of today’s workforce.

What is a custom target date fund?

In basic terms, a target date fund is a one-step option with a mixture of investments based on the amount of time a participant has until retirement. Asset allocations are designed to become more conservative by shifting to lower risk investments as the participant ages. This is known as the “glide path”—which changes as the investment vehicle gets closer to its target date (or retirement year).

A “custom” or “semi-custom” TDF allows the plan sponsor to pick and control the underlying options, often from their plan menu, rather than pre-set investments. In the past, a typical target date retirement fund included only proprietary funds of the TDF provider. Now they come in multiple combinations.

Custom target date funds can provide investment manager diversification. An advisor and plan sponsor can assemble the underlying options from the existing plan’s core line-up or other sources, broadening manager diversification. For example, a custom TDF may consist of actively managed funds, passive index funds or stable value funds, or a mix of these options.

Sponsors can easily replace underperforming managers without terminating and replacing the fund, which often triggers specific requirements for participant notifications and other actions specified in the plan document. When using funds from the core lineup, no additional due diligence is necessary.

Workforce fit

Plans can also implement more flexible glide paths to support varying participant demographics. For example, if an organization also offers a pension plan, older participants in the 401(k) plan may not want or need high fixed income allocations as they approach retirement. Instead, the asset allocation can be weighted with more equity exposure.

Other company characteristics can be factored in. For example, a plan sponsor in the energy sector could underweight certain commodities such as oil, since its participants already work in that industry, and in so doing better manage their risk exposure.  

Fiduciary considerations and a nudge from the Department of Labor

Under the Employee Retirement Income Security Act (ERISA), a plan sponsor must act in the best interest of participants and for the exclusive purpose of providing them with benefits. ERISA’s “prudent man” rule requires plan sponsors to act prudently in the selection and monitoring of plan investments – including custom TDFs. ERISA also urges plans sponsors to assess fees in terms of the value of the services provided, beyond seeking the lowest cost. This value consideration should be weighed when evaluating custom TDFs, as it can be argued that they provide additional services for participants.

Based on the popularity of TDFs, in 2013 the Department of Labor (DOL) took the step of releasing guidance suggesting that plan sponsors look into custom TDFs for their plan, stating:

“Inquire about whether a custom or non-proprietary target date fund would be a better fit for your plan. Some TDF vendors may offer a pre-packaged product which uses only the vendor’s proprietary funds as the TDF component investments. Alternatively, a ‘custom’ TDF may offer advantages to your plan participants by giving you the ability to incorporate the plan’s existing core funds in the TDF. Non-proprietary TDFs could also offer advantages by including component funds that are managed by fund managers other than the TDF provider itself, thus diversifying participants’ exposure to one investment provider.”

This guidance was well received by the industry. “The DOL guidance was welcome insight for plan sponsors contemplating their TDF strategy. This resource, along with other third-party information and the assistance of advisors, can help plan sponsors research and evaluate the right TDF approach for their plan,” says Brian Dobbis, Director, Retirement Solutions at Lord Abbett.

Target date funds and custom models continue to dominate

Target-date solutions reached $1.77 trillion at year-end 2018, according to Sway Research.3 By 2021, 85% of participant contributions are expected to go to target-date strategies, and, by 2020, target-date strategies should have more assets than any other option in defined contribution plans. 1

Fueling their growth is a vast majority of participants automatically enrolled into target-date strategies as the qualified default investment alternative (QDIA). Auto-escalation programs and re-enrollment of participants into default target-date options have also driven up assets. 4

Custom target-date solutions continue to dominate target-date assets among the largest plans. Plans in the top 200 of the 1,000 largest plans in the country reported $185.1 billion in custom target-date strategies as of September 30, 2017, up 19.8% from a year earlier. This compares to $44 billion that was invested in off-the-shelf strategies as of September 30, 2017, up 36.6% from 2016. 3

What are the trends?

Target date funds’ explosive growth continues primarily because of the appeal of professional management of a participant’s asset allocation, fund selection, and glide path. The movement to custom models is largely borne out of a primary criticism that pre-packaged funds employ a “one size fits all” approach.

“Historically, TDF managers had little incentive to offer open-architecture solutions” says Adam Backman, Partner, Product Strategy for Lord Abbett. “As plan sponsors demand increased flexibility, investment managers are responding with additional choice.”

Daniel Bruns, Vice President, Strategy at Morningstar Investment Management LLC reports that he sees a push towards more customized solutions among plan sponsors. “Plan sponsors are realizing that customized defaults such as custom target solutions or managed accounts often allow for a better fit with plan demographics than off the shelf solutions.” He adds: “When you combine the better fit that customized solutions can provide with the price compression that we’ve seen over the past five years, custom solutions are becoming more attractive.”

Bruns says he is also witnessing interest from both small- and large-sized plan sponsors. “We are seeing smaller retirement plans embrace custom target date solutions, specifically semi-custom solutions, which use technology and improved recordkeeper connectivity to bring custom target date down-market in a scalable, efficient way,” he says.

What is specifically driving plan sponsor interest?

For their part, plan sponsors cite multiple reasons for adopting custom TDFs. Callan Institute’s 2019 Defined Contribution Trends survey4 ranked the top five motivations as follows:

Are custom target date funds a fit for your practice?

Consulting on custom TDFs enhances your value to a plan sponsor and can help you forge a deeper relationship with your clients. If you haven’t added this solution to your advisor tool kit, perhaps now is the time. Your expertise can differentiate your services from other advisors, for example, who only offer pre-packaged TDF solutions, and help solidify your reputation as a thought leader.

At Lord Abbett, we can help you think through the various considerations when recommending custom TDFs to your clients, including the fiduciary considerations. By recommending custom models, you can highlight the various strengths and roles of your advisory practice, including:

• Portfolio strategy, as you help guide your clients with fund selection and monitoring.
• Fiduciary guidance with support for provider due diligence, benchmarking, fee comparison and fiduciary documentation. If your firm doesn’t serve as a fiduciary, there are fiduciary support services you can leverage to supplement your offering.
• Education and implementation support including facilitating participant education, identifying recordkeeper capabilities, coordinating glide path creation and creating an Investment Policy Statement.

Talk to us at Lord Abbett. We can help you develop a custom retirement solution for your clients.

Ask your Lord Abbett Regional Manager about how we can assist you in evaluating and constructing a menu of custom target date funds that best meet the needs of your clients. Together, we can put the resources and solutions of Lord Abbett to work for your client.

For more information, contact us at 888-522-2388.