TDFs’ Underlying Funds May Not Meet Plan Sponsors’ IPS Standards

Proprietary products may prevent managers from unloading poorly performing funds

Retirement plan sponsors have a duty to screen target-date fund offerings. However, a January analysis by Janus wonders if they’re doing enough to vet the underlying funds in TDFs.

Seventy percent of the target-date funds analyzed in the report include underlying managers who would fail to meet customary investment policy statement (IPS) standards in at least two categories.  

“Plan fiduciaries who comply with a well-constructed IPS take an important step toward meeting certain [Employee Retirement Income Security Act] responsibilities, including the duty of prudence,” authors Matt Sommer and Joel Evenhouse wrote. “Among other things, an IPS defines criteria that sponsors use to evaluate and, if necessary, replace certain underperforming managers.”

However, they claim that most plan sponsors fail to consider whether the underlying funds in the TDFs they offer could pass the same performance standards as the core managers.

That’s important because 60% of plan sponsors believe TDFs are the best choice for a qualified default investment alternative for their employees, according to a 2016 survey by Janus and Plansponsor. The largest plans are the most likely to use target-date funds as the QDIA; 85% of plans with more than $1 billion in assets said they use the funds as the qualified default, according to the study of approximately 4,600 plan sponsors.

The report analyzed the underlying funds in the 10 largest 2040 target-date funds by assets, as determined by Morningstar, to see what percentage of those funds would meet a sample IPS criteria. To meet the standards in Janus’ sample IPS, the funds must be at least five years old, with a manager who has served at least that long, and expense ratios must be in the best 50%. One-, three- and five-year performance must be in the top half for the fund’s peer group, and Sharpe ratios for the same periods must be at least median for the peer group.

Only one TDF manager (who Janus did not name) met all of these standards with 75% or more of the underlying funds. In five of the top 10 funds, less than half of underlying managers met the five-year performance and Sharpe ratio criteria (and at one of those, underlying managers also failed to meet one-year and three-year performance criteria).

Sommer and Evenhouse stressed that these results don’t immediately suggest a TDF manager is doing a bad job. “Remember that 94% of the variability of returns is due to the asset allocation, not security selection,” they wrote.

However, sponsors have to wonder why a manager would keep those poorly performing funds in the TDF instead of replacing them with something better able to maximize risk-adjusted goals. Janus’ 2016 survey of plan sponsors provides a possible answer: 41% of sponsors, and 63% of large plan sponsors, use proprietary TDF solutions.

“The inherent conflicts of interest should be clear: How can Manager E possibly replace an underlying fund that is also managed by his own company, especially when a superior alternative is offered by a competitor?” Sommer and Evenhouse asked.

They suggested two possible solutions. In a model portfolio approach, plan administrators create a set of model TDF portfolios using funds in the plan’s core lineup. Asset allocation across those funds are set by the model portfolio chosen by the participant.

Alternatively, a trust unitization approach establishes each target-date portfolio as a separate account in a trust and as an individual investment option on the recordkeeping system, according to the paper.  

“In both cases, plan sponsors are able to leverage the effort already used to select and monitor the plan’s core menu,” they wrote. “This approach ensures that only managers that meet strict IPS criteria are used to build the plan’s target-date funds.”

--- Read Americans Are Putting Billions More Than Usual in Their 401(k)s on ThinkAdvisor.

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