Christopher O’Dea finds defined contribution pension sponsors are increasingly looking for more flexibility in target-date funds to cope with changing worker demographics
At a glance
• Retirement readiness in the US is low at a time when the over-65 population cohort is expanding.
• Target-date funds (TDFs) have rapidly become the most popular investment option in defined contribution (DC) plans, serving as the default option in many.
• Now DC plan sponsors are evolving – shelving TDFs from record-keepers in favour of more flexible options, while adding financial wellness counselling to boost the productivity of participants.
Like weekend pilots eager to buck the pull of gravity and soar between mountain peaks, defined contribution (DC) plan sponsors in the US are pursuing new glidepaths.
Target-date funds (TDFs) have rapidly become the go-to solution for DC plan sponsors acutely aware that their ageing participants will not be able to count on the balances in 401(k) accounts to replicate even half the level of income they earned during their working years. According to Aon Hewitt, 40% of new contributions to DC plans is invested into a TDF, with TDFs accounting for 24% of asset allocation in 2015, up from 15% just two years ago.
“Target-date funds have become the default election for the majority of DC plan sponsors and the asset flows into them are significant,” says Winfield Evens, partner and director of HRO investment solutions and strategy at Aon Hewitt. A TDF has become “the largest plan option for most sponsors and gathers the lion’s share of contribution into the plan”, he says.
According to the 2017 Defined Contribution Trends Survey by Callan Associates, nearly 93% of the 165 plans sponsors responding to the survey offer a TDF as of 2016, and more than 88% used a TDF as the default option in 2016, up from 75% in 2012. With the increasing focus on the fiduciary responsibility of plan sponsors in the US, says Evens, the key investment decision now facing many sponsors is whether they have the right TDF – or series of TDFs – in the DC plans they provide to employees.
Most of the time, the right fund is not a proprietary TDF of the plan’s record keeper, a marked change over the past several years. Such funds accounted for less than 30% of the TDF offerings by plan sponsors Callan surveyed in 2016, down from nearly 60% in 2012. Customised target-date funds accounted for more than 22% of the TDF offerings in 2016, with cost-efficient target-date collective investment trusts accounting for nearly 21% of the TDF landscape; those vehicles accounted for about 10-15% of target-date assets in 2012.
“Over the past few years, the types of target-date funds used in DC plans have evolved dramatically,” says Lori Lucas, executive vice-president and defined contribution practice leader for Callan. “Plan sponsors have re-examined these funds in light of changing workforce demographics, changes in the level of assets in the plan’s target-date funds, and even changes in the target-date funds themselves,” she adds. “There is recognition both of how complex target-date funds are, and of how important these funds have become within the plan.”
The move away from funds offered by a plan’s record keeper in part reflects regulatory guidance encouraging plan sponsors’ vigilance in the design of target-date funds and the selection of investment managers. A letter from the US Department of Labor (DoL) in 2013, Target Date Retirement Funds – Tips for ERISA Plan Fiduciaries, drew attention to the ‘open versus closed’ paradigm by specifically urging plan fiduciaries to revisit their target-date fund selection, says Jessica Sclafani, associate director at Cerulli Associates.
The DoL guidance suggested to plan sponsors that a recommended practice when choosing a target-date fund would be to “inquire about whether a custom or non-proprietary target-date fund would be a better fit for your plan,” Sclafani says. Furthermore, she adds, the DoL pointed out that “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”.
“Over the past few years, the types of target-date funds used in DC plans have evolved dramatically”
While plan sponsors have been reducing the use of TDFs managed by plan record keepers, target-date assets remain highly concentrated, according to Cerulli, with the top five providers managing 81% of the $1trn (€950bn) in target-date assets in collective investment trusts and mutual funds at the end of 2015. Vanguard, Fidelity Investments and T Rowe Price have market shares of 34%, 18% and 15%, respectively. Of that, assets in 401(k) plans accounted for $853bn.
A Cerulli analysis of target-date funds last summer concluded that “the importance of an asset manager’s strategy for participating in the target-date fund market has only grown in recent years and shows no sign of decreasing”. Managers are walking a narrow path. According to a proprietary survey of 26 target-date providers conducted by Cerulli in 2016, most managers do not plan to create new off-the-shelf target-date funds. But there is a middle ground – nearly 30% told Cerulli they offer custom glidepath services for plan sponsors that want a glidepath structure tailored to the profile of their participants.
It is a smart approach; Callan’s 2017 DC Trends survey found that tailoring the glidepath has become plan sponsors’ top priority, by a wide margin. Of the nearly 49% of plan sponsors surveyed that took action regarding their target-date fund line-up in 2016, Callan says “evaluating target date suitability maintained its place as the most prevalent course of action”, with nearly 67% checking the glidepath in 2016 and almost 35% planning to do so in 2017. A distant second on sponsors’ to-do list for 2017 is changing TDF share classes, contemplated by fewer than 6% of sponsors.
The boom in TDF assets has coincided with growing concern in the US about the lack of retirement savings for most citizens. According to an OECD benchmark of income replacement in retirement, only 45% of the average American’s average lifetime earnings can be replaced by purchasing an annuity at retirement, assuming a 2% real interest rate.
That leaves a big gap. A study by plan administrator SEI found that 84% of plan sponsors do not have high confidence that their plan participants will have the needed amount of income to retire at the prevailing retirement ages of 62 to 65. If employees decide they cannot stop working at retirement age, the majority of plan providers SEI asked – 88% – fear meaningful negative financial consequences from increased healthcare costs, difficulty retaining younger employees blocked from advancement, and the expense of higher-salaried older employees.
That has heightened attention on DC plans. More than half now have automatic enrolment features, says Aon Hewitt’s Evens. The basic approach is to default participants into the plans, most often to a TDF. To further boost participation, sponsors undertake re-enrolments, a process that entails extensive communication to encourage participation. SEI says nearly 40% of sponsors planning to conduct a re-enrolment through July 2017 also plan to introduce target-date options customised to the demographic profile of participants.
Consultants say the emerging practice of plan sponsors providing financial wellness counselling and tools promises to be the next big thing in the US defined-contribution market. Plans sponsors have realised that persuading employees to enroll in DC plans “is part of the overall puzzle for the participant”, says Evens. The adoption of the TDF as the default option in many DC plans reflects a broader trend in which plan sponsors are taking a more holistic view of participants’ financial health – and the opportunity to improve productivity by helping employees reduce the stress that can arise from financial insecurity.
In short, Evens says, productivity can suffer if employees are anxious about their personal financial well-being. Plan sponsors are now creating programmes to provide counselling and tools for everything from household budgeting to education finance, tailored to the needs of each sponsors’ workforce. While an investment bank and a retailer might offer very different benefits. “Plan sponsors see it as a virtuous cycle,” says Evens. Perhaps most importantly, he adds, “it’s the right thing to do.”