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Knowledge. Experience. Integrity.
CALLAN INVESTMENTS INSTITUTE
Research
September 2015
Target Date Funds
Finding the Right Vehicle for the Road to Retirement
There seems to be no stopping target date fund (TDF) strategies, which are growing both in use within
defined contribution (DC) plans and in products available. Each TDF manager differs in their underlying
philosophy, which shapes construction and implementation.
The wide variety of options represents both a benefit and a challenge. As plan sponsors examine and
monitor TDF options they must be aware of the differences and how these differences can ultimately
affect participant outcomes.
This paper draws on Callan’s comprehensive data on TDFs and DC plans, which is gathered and ana-
lyzed annually. We present key findings and highlight questions plan sponsors may want to consider
when evaluating their TDF options.
“Nobody with a good car needs to worry about nothin’, do you understand?”— Hazel Motes in John Huston’s “Wise Blood” (1979)
Just as people rely on cars to get them where they need to go, Americans increasingly depend on
TDFs to help them achieve their retirement goals. For the first time since the inception of the Callan
DC Index™ in 2006, TDFs (25%) recently beat out U.S. large cap equity (24%) as the largest portfolio
allocation in DC plans. As part of Callan’s annual DC Trends Survey, more than 140 DC plan sponsors
were asked about their use of TDFs. Callan also annually collects qualitative and quantitative data from
target date managers representing both mutual funds and collective trusts. This paper leverages this
combined data to examine the current state of the TDF universe and the differentiating characteristics
that help drive outcomes.
2
A Look Inside the Showroom: The TDF UniversePlan sponsors face a plethora of options—there are more than 40 off-the-shelf, unique target date series
(including both mutual funds and collective trusts)—and they range widely in implementation approaches.
While there are more active TDFs than passive (70% have some active management, see Exhibit 1),
DC plans typically adopt passively managed TDFs. However, even those TDFs with completely passive
implementation still must make active decisions regarding the strategic construction of the glide path—the
implementation may exclusively utilize index funds, but the asset al-
location decision is active.1 No target date suite is truly 100% passive.
Active Passive Blended
Products 41% 31% 29%
Plan Utilization 35% 42% 24%
Source: Callan, utilization figure from Callan’s 2015 DC Trends Survey
Across the universe of TDFs, providers utilizing their own under-
lying funds predominate (61%). The remaining managers (40%)
offer some degree of open-architecture (non-proprietary) funds
within the target date glide path, such as index funds or ETFs.2
Mutual funds continue to be the most common investment vehicle
for target date products (Exhibit 2). Mutual funds enable managers
to address both the 401(k) market and the growing 403(b) market.
Roughly one-third of managers make both mutual fund and collective trust versions of their TDFs available.
Often the collective trust is targeted to the institutional market and the mutual fund at the retail market and
advisor channel. Only 11% of managers exclusively offer collective trusts. These managers might focus
primarily on the institutional market or view the lower cost of setting up a collective trust as the main reason
to eschew the mutual fund world.
Note: Throughout this paper, charts and data may not sum to 100% due to rounding.1 “Glide path” refers to the gradual change in asset allocation as a participant ages.2 Some may question whether the use of non-proprietary index managers truly constitutes an “open-architecture” solution.
Exhibit 1
Product Offerings and Utilization
Exhibit 2
Vehicle Availability
Source: Callan
Mutual Funds 56.8%
Both31.8%
Collective Investment Trusts 11.4%
Life in the Fast Lane
Since 2010, six providers have
exited the target date space
but eight have entered it. Man-
ager exits are frequently due to
difficulties in garnering assets.
The TDF market historically
has been dominated by those
with recordkeeping arms that
can significantly help with dis-
tribution. Existing target date
providers also have the ability
to add more glide path offer-
ings to their product lineup.
3Knowledge. Experience. Integrity.
Sticker Price: The Going Rate for TDFsThe choice of underlying funds and vehicles largely drives fees. Looking at the lowest-cost share class
and trust class in the collective trust and mutual fund universes, Callan’s database shows the median
fee is 60 basis points. The overall range, which has widened slightly compared to previous years,
goes from 16 basis points at the cheapest end (10th percentile) of the spectrum to 82 basis points at
the most expensive (90th percentile). From the manager’s perspective, these fees include investment
management and sometimes reflect an additional fee for the asset allocation work that goes into target
date design. Increased competition, particularly among index TDF providers, has led to a downward
trend in fees.
Plan sponsors’ concerns about potential fee litigation has exerted more downward pressure on fees.
The median fees of near-term vintages, such as 2010 funds, shrunk by six basis points (from 0.65%
to 0.59%), while longer-term vintages have experienced an even greater decrease in fees over the
last five years (Exhibit 3). Interestingly, even as TDFs’ equity allocations have declined relative to
2010, their composition has shifted toward more expensive asset classes, such as emerging markets.
Providers typically are able to reduce overall fees by offsetting more expensive sources of equity with
increased allocations to passive U.S. large cap equity. This allows managers to stay within their “fee
budget” and remain competitive while also incorporating more diversifying asset classes.
0.0%
0.5%
1.0%
2050 Fund2040 Fund2030 Fund2020 Fund2010 Fund
0.65%0.59%
0.74%
0.62%
0.77%
0.66%
0.79%
0.66%
0.81%
0.70%
2010 2015Calendar Year
Med
ian
Fee
Vintage
Exhibit 3
Median Investment Management Fees for Target Date Funds
Source: Callan
Plan Sponsor Considerations: TDF Implementation• Are you comfortable with your target date manager’s overall implementation?
• Are you aware of what underlying asset classes are passively implemented?
• Does your manager offer your TDF in a lower-priced vehicle? If so, are there differences in the
underlying implementation?
4
Fuel Injectors: The Evolution of Equity ExposureThe 2008 bear equity market was a catalyst for many changes to TDFs, primarily to risk management.
Due in part to aggressive equity allocations, many of these supposedly staid funds experienced losses of
25% or more. Returns for managers of 2010 TDFs during the crisis ranged from -29.0% (90th percentile)
to -14.5% (10th percentile) with a median of -22.7%.
In general, TDF providers reduced equity exposure after 2008 (Exhibit 4). The red line representing the
average equity rolldown of TDFs today is lower throughout the glide path than the green line (2010). Equity
allocations were even lower in 2012. For example, the average equity allocations for 45-year-old participants
Exhibit 4
Equity Exposure by Age
Source: Callan
20%
40%
60%
80%
100%2010 2015
25 30 35 40 45 50 55 60 65 70 75 8580
Age
Calendar Year
Equi
ty E
xpos
ure
Plan Sponsor Considerations: Fees• How competitive are your provider’s fees?
• Has the provider added value commensurate with their level of fees?
• Have you benchmarked fees to appropriate peer groups (e.g., active/passive and vehicle type)?
• Does your fee reflect only the underlying investments or is there an additional layer of fees for
asset allocation/manager selection?
5Knowledge. Experience. Integrity.
Exhibit 5
Age 45 Equity Exposure
(a 2035 fund) declined from a high of 79% post-market crash in 2009 to a low of 70% three years later
(Exhibit 5). Interestingly, the average equity allocation crept back up as markets remained strong over the
next few years. Today, the average equity allocation has rebounded to nearly 74%. This increase came as
managers revised their long-term capital market expectations, which inform their strategic glide path deci-
sions. It also reflects the competitive reality that more conservative glide paths have struggled to keep pace
with their aggressive brethren during the prolonged U.S. equity bull market that began in 2009.
Source: Callan
60%
65%
70%
75%
80%
2015201420132012201120102009
Aver
age
Equi
ty E
xpos
ure
79%
76%
72%
70%
71%
73%74%
Calendar Year
Plan Sponsor Considerations: Glide Path Changes• Does a strategic change in the glide path significantly alter the return-risk trade-off of the glide
path? If yes, is it still appropriate for the defined contribution participant base?
• What is the long-term strategic rationale for the glide path change?
• If there have been changes to the equity-to-fixed-income mix, has the composition of sub-asset
classes within equity and fixed income also changed?
• Have glide path changes resulted in changes to the fee schedule, and are the changes reasonable?
6
Exhibit 6
Age 45 Average Allocations to Various Asset Classes
Exhibit 7
Prevalence of Various Asset Classes Across Glide Paths
Additional Features: Asset Class OptionsIn general, strategic allocations to less-common asset classes such as absolute return, commodities, non-
U.S. fixed income, and emerging markets equity have increased. Exhibit 6 shows the overall average stra-
tegic allocation3 to various asset classes for a 45-year-old participant (2035 fund). While allocations to these
3 Allocations reflect strategic weightings; the actual allocations could be greater or less (see next section on the use of tactical management).
U.S. REITs
Cash Equivalents
TIPS
Global REITs
High Yield
Commodities
Absolute Return
Non-U.S. Fixed
Emering Market Equity
Small-Mid Cap
Core Fixed Income
Non-U.S. Equity
Large Cap
13%
38%
19%
11%
2%
2%
1%
2%
2%
1%
2%
2%
5%
Non-U.S. Fixed (Hedged)
Stable Value
Long Gov
Real Estate
Non-U.S. Small Cap Equity
Bank Loans
Absolute Return
Natural Resource Equity
Short Duration
Emerging Market Debt
U.S. REITs
Cash Equivalents
Non-U.S. Fixed (Unhedged)
Commodities
High Yield
Global REITs
Emerging Market Equity
TIPS
SMID Cap U.S. Equity
Developed Non-U.S. Equity
U.S. Fixed Income
Large Cap U.S. Equity
96%
100%
100%
100%
68%
50%
48%
46%
43%
36%
27%
25%
25%
21%
18%
9%
7%
5%
5%
2%
2%
61%
Source: Callan
Source: Callan
7Knowledge. Experience. Integrity.
asset classes remain small, their presence in glide paths appears to be increasing. For example, while the
average TDF offers just a 1.7% exposure to absolute return strategies, such strategies are now present
in nearly one in five TDFs.4 Of those providers utilizing absolute return strategies, the allocations ranged
from 1% to 40% at various points along the glide path. As Exhibit 7 shows, active managers are expand-
ing into hard-to-index asset classes such as emerging market debt (25.0%), bank loans (9.1%), and non-
U.S. small cap (6.8%). Even direct real estate, which in the past bedeviled managers and plan sponsors
with liquidity and valuation concerns, is present in a small number of TDFs.
Tactical Implementations: Air Bags or Nitrous?Tactical implementation goes by many names (i.e., dynamic strategies, active implementations, proactive
strategies). Regardless of the nomenclature, these approaches all seek to add value—whether by risk re-
duction or alpha generation—through short-to-intermediate-term deviations from the strategic glide path.
These tactical shifts should be differentiated from managers that deviate from their strategic weights due
to market activity or cash flows. Instead, tactical implementations are characterized by intentional over- or
under-weights relative to the TDF’s long-term strategic allocations.
When looking at the prospectuses for various TDFs, the allowable rebalancing ranges around the strate-
gic weights often vary widely. A wide rebalancing range can prove beneficial if events beyond a manager’s
control necessitate extreme measures with regard to the underlying allocation. In some cases, managers
will include language that allows them to allocate completely to cash in emergency situations.
An examination of the aforementioned 44 managers’ prospectuses and offering documents (for collective
trusts) reveals that the average range for those with tactical leeway in equities is +/-14%. Nearly one-third of
all managers left the allowable range completely open-ended; 59% cited some degree of tactical manage-
ment in their disclosure documents. Despite the range of tactical shifts allowed, in practice many managers
rarely use their full tactical allowance. While the average allowable band might be +/-14% for those em-
ploying tactical management, the average absolute deviation5 from the strategic equity weighting is 5.4%.
If three outliers are removed, the average falls to 3.3%. As of June 2015, 58% of tactical managers were
underweight their strategic equity benchmark while 40% were overweight.
4 The use of alternatives within TDF glide paths will be discussed in more detail in a follow-up paper.5 The average deviation is the actual allocation (as of 6/30/15 or most recently available) versus the stated strategic weights.
Plan Sponsor Considerations: Asset Allocation• Are allocations to various asset classes meaningful enough to affect outcomes?
• What is the rationale for adding/eschewing a certain asset class?
• Are there asset classes a manager would like to include but cannot due to limitations like cost,
lack of a proprietary product, lack of a relevant index, or other operational reasons? Are these
limitations acceptable?
• Have allocation changes resulted in changes to the fee schedule, and is the change acceptable?
8
To see the potential impact on performance, consider the consensus 2020 fund. Exhibit 8 illustrates the
effect on annualized returns resulting from shifting the equity6 allocation, whether the manager makes a
good call (2.5% bull market) or a bad call (97.5% bear market). The baseline scenario represents a man-
ager remaining true to their strategic allocation.
Equity ScenarioTactical Shift in Equity
Bear Equity Market 97.5%
Bull Equity Market 2.5%
Standard Deviation
-14% -8.8% 19.4% 6.8%-10% -8.5% 22.5% 7.5%-5% -10.4% 24.8% 8.4%-3% -11.2% 25.7% 8.8%Baseline -12.3% 26.9% 9.4%+3% -13.1% 28.3% 9.9%+5% -13.6% 29.2% 10.3%+10% -15.6% 31.4% 11.3%+14% -17.1% 33.0% 12.1%
Source: Callan
For example, a 14% reduction in equity (relative to the strategic baseline) in a period where equity out-
performs (“bull market”) would result in 7.5% underperformance relative to the baseline (19.4% versus
26.9%). Contrast this with the same 14% underweight to equity during the “bear market,” which would
represent 3.5% outperformance relative to the baseline (-8.8% versus -12.3%). Modest tactical shifts
can mean similar shifts in potential outcomes. Just as a manager can enhance the risk-return profile
by taking equity off the table, they can also decrease the risk-return profile. This underscores the im-
portance of understanding the extent to which a manager is employing tactical shifts and the purpose
of these shifts.
The fact that the actual deviation from the strategic allocation tends to be so much lower than the al-
lowable deviation reflects the fact that most managers prefer to be conservative in this area. In other
words, just as a car’s speedometer may go up to 180 m.p.h., but few drivers will ever reach that level,
few TDF managers expect to deviate very widely from their strategic asset allocation. Indeed, TDF man-
agers often employ an internal risk-control structure based on maintaining fairly low tracking error. One
manager recently explained that despite a 10% allowable range, a 3% move would exceed his internal
tracking error limit; therefore, a move beyond 3% is not expected. Tactical overlays are often utilized for
risk mitigation purposes or for modest return enhancement (i.e., 20-25 basis points of added returns).
Even so, it is important not to downplay the role of tactical asset allocation in some TDF strategies—as
well as how new to tactical asset allocation some of these managers may be.
6 Equity increases in proportion to underlying allocation. Increases are funded from the allocation to core fixed income.
Exhibit 8
Effect of Equity Shifts on One-Year Performance
Und
erw
eigh
tO
verw
eigh
t
9Knowledge. Experience. Integrity.
Indeed, with short track records and somewhat opaque return attributions, the implementation effects of
tactical management remain somewhat nebulous. Exhibit 9 shows the glide path versus implementation
return for a sample TDF manager (“XYZ”). While the glide path return is just the return attributable to a
passive implementation of the strategic asset allocation, this implementation return will include the effects
of active management as well as any effects of deviations from the strategic benchmark weightings.
In the case of Manager XYZ, the one-year total return of 4.10% exceeded the one-year glide path return of
3.42%. This means that Manager XYZ added 68 basis points over the past year through implementation.
Parsing the 68 basis points further would require a look at each underlying component of the target date
series. Clearly, for such attribution analysis to be useful there must be a detailed understanding of the man-
ager’s strategic asset allocation. In other words, if Manager XYZ does not provide a complete set of custom
benchmarks outlining the intended strategic asset allocation, it would be possible to confuse implementation
return with the return attributable to the strategic asset allocation—thus over- or understating Manager XYZ’s
value added. Examining how actual allocations have deviated over time from the strategic allocations and
the magnitude of the deviations serves as a starting point. Additionally, the tools used to implement tactical
Source: Callan
Last Last Last Year 3 Years 5 Years 10th percentile 4.25 12.94 12.91 25th percentile 3.30 12.38 12.60 Median 2.64 11.63 11.52 75th percentile 1.39 10.15 10.61 90th percentile 0.00 7.95 9.46 Manager XYZ 4.10 11.32 11.34 Glide Path Return 3.42 10.45 11.45
Implementation Return 0.68 0.87 -0.11
-5%
0%
5%
10%
15%
AB
A (12)B (23)
A (56)B (65)
B (51)A (52)
Exhibit 9
Glide Path Versus Implementation Return
TotalReturn
Implementation Return
Glide Path Return
= +
Beta from underlying asset allocation
Alpha from active managers + effects of tactical shifts + any other implementation effects (rebalancing)
10
shifts must also be understood. These tools vary from simply allocating to various underlying funds using
cashflows and actual trading, to using derivative instruments to achieve the desired results. In the case of
the latter, the precise nature of the instruments and the inherent leverage embedded (paying attention to the
actual percentage of notional value posted) must be understood. Only after examining these factors should
one claim to be comfortable with a manager’s use of tactical management.
TDF Tuneup
Plan sponsors should occasionally revisit their selection of a
target date provider to examine how their provider’s imple-
mentation decisions may affect potential outcomes. Useful
best practices may be found in the Employee Benefits Secu-
rity Administration’s (EBSA) guide: “Target Date Retirement
Funds: Tips for ERISA Plan Fiduciaries” (2013). EBSA’s goal
is “to assist plan fiduciaries in selecting and monitoring TDFs
and other investment options in 401(k) and similar participant-
directed individual account plans.” It lists eight key points:
1. Establish a process for comparing and selecting TDFs2. Establish a process for the periodic review of selected TDFs.3. Understand the fund’s investments – the
allocation in different asset classes (stocks, bonds, cash), individual investments, and how these will change over time
4. Review the fund’s fees and investment expenses
5. Inquire about whether a custom or non-proprietary target date fund would be a better fit for your plan
6. Develop effective employee communications7. Take advantage of available sources of information to evalu-
ate the TDF and recommendations you received regarding the TDF selection
8. Document the process
The guide also references the Department of Labor’s (DOL)
2012 participant disclosure requirements and points out that
“while TDFs are relatively new investment options, there are an
increasing number of commercially available sources for infor-
mation and services to assist plan fiduciaries in their decision-
making and review process.” Language like this suggests that
from the DOL’s perspective, a higher standard may apply to
target date fund decision-making going forward than has been
applied in the past.
Plan Sponsor Considerations: Tactical Management• Does your TDF manager utilize tactical management? If so, what have been the historical devia-
tions from the strategic benchmark weightings?
• What is the goal of the tactical component? Is there a stated return goal over time? How has the
manager’s tactical implementation performed historically?
• What is the decision-making process and the timeframe used to make tactical decisions? Does
the manager have experience making tactical decisions?
• How are tactical decisions implemented?
• What is the track record of the tactical decision, and what is the associated cost?
11Knowledge. Experience. Integrity.
ConclusionJust as a potential car buyer faces many choices when making a purchase, so too do plan sponsors when
considering their target date options. Strategies may be active, passive, tactical, or strategic. The manager
may offer different investment vehicles (e.g., mutual funds, collective trusts) each with its own criteria, pros,
and cons. Each target date manager differs in their underlying philosophy, which shapes construction and
implementation. The wide variety of options represents both a benefit and a challenge. As plan sponsors
monitor target date funds and managers, they must examine any changes and assess how these changes
may ultimately affect participant outcomes.
In the next paper in this series, the conversation will move from the showroom and into the factory. We will
move beyond the current landscape to examine target date construction—how plan characteristics can
inform choice and what the future of the target date landscape may hold.
12
About the AuthorJames Veneruso, CFA, CAIA, is a vice president and defined contribution consultant in
Callan’s Fund Sponsor Consulting group based in the Chicago office. Jimmy joined Callan
in 2007 and is responsible for providing analytical support to Callan’s DC clients and consul-
tants including investment structure evaluations, fee analyses, and target date fund research.
He is a regular speaker at the “Callan College” and various investment forums. Jimmy is a
shareholder of the firm. Prior to joining Callan, Jimmy served over two years as a United States Peace
Corps Volunteer in the Kingdom of Tonga. He served as project manager for the Future Farmers of Tonga
program and taught at Queen Salote College. Jimmy received his master’s in economics from University
of Illinois and graduated with departmental honors earning a BS in computer science and economics at
Vanderbilt University. He has earned the right to use the Chartered Financial Analyst designation and the
CAIA designation. Jimmy is a member of the CFA Society of Chicago.
Certain information herein has been compiled by Callan and is based on information provided by a variety of sources believed to be reliable for which Callan has not necessarily verified the accuracy or completeness of or updated. This report is for informational pur-poses only and should not be construed as legal or tax advice on any matter. Any investment decision you make on the basis of this report is your sole responsibility. You should consult with legal and tax advisers before applying any of this information to your particular situation. Reference in this report to any product, service or entity should not be construed as a recommendation, approval, affiliation or endorsement of such product, service or entity by Callan. Past performance is no guarantee of future results. This report may consist of statements of opinion, which are made as of the date they are expressed and are not statements of fact. The Callan Investments Institute (the “Institute”) is, and will be, the sole owner and copyright holder of all material prepared or developed by the Institute. No party has the right to reproduce, revise, resell, disseminate externally, disseminate to subsidiaries or parents, or post on internal web sites any part of any material prepared or developed by the Institute, without the Institute’s permission. Institute clients only have the right to utilize such material internally in their business.
If you have any questions or comments, please email [email protected].
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