A TDF primer for DC plan sponsors.
TDFs have become staples of DC retirement plans over the past decade. But in moving to TDFs, plan sponsors can learn from the mistakes that money managers and other sponsors have made along the way. Here are five of the most common.
1. Making unrealistic assumptions – Plan sponsors wrongly assume that members understand basic investment principles and have the discipline to follow them. However, S&P data since 2000 for cumulative net equity exchanges (money flowing in and out of stock funds) show that investors fail at dollar-cost averaging, buying when prices are rising and selling when they are falling. And post-retirement withdrawal rates are often much higher than plan sponsors and investment managers expect. Asset allocation should reflect these realities.
2. Misusing DB tools in a DC setting – Popular tools used to construct DB portfolios such as mean variance optimization, which aims for an optimal mix of assets, are incomplete when applied to DC portfolios because they ignore sequence risk: the risk that the order of returns may affect the realized return. In DC plans, timing and sequence can have a dramatic impact on TDF returns when bull and bear markets occur. Plan sponsors should ask their TDF providers how they manage sequence risk.
3. Failing to create a proper glide path – Plan sponsors are often presented with attractive but unworkable glide paths. A straight-line glide path looks elegant but prematurely reduces investors’ risk. A stair-step glide path takes on unnecessary timing risk. An arc-shaped glide path, while an improvement over the other two, may ignore the open-ended structure of DC plans and make an assumption about the homogeneity of the employee base. When designing glide paths, sponsors must consider the heterogeneous nature of an employee base.
4. Failing to differentiate between glide path design and management style – Plan sponsors often confuse glide path risk and active risk. Just because a TDF is passively managed does not necessarily mean that it is less risky. A passive fund that has extremely high amounts of equity, for example, has a high amount of equity risk. Plan sponsors should get comfortable with the risk profile of a glide path before they address the active versus passive debate.
5. Using a smorgasbord approach – Simply adding TDFs to the menu of options serves nobody in the end. DC plan design has been moving to a three-tier structure. Tier 1 (often the default) is the TDF, which 80% to 85% of the employee base is expected to choose.
Tier 2 is a simple menu of core funds for employees with the skill and motivation to assemble their own custom mix of funds. It’s expected that 10% to 15% of the employee base fits this description. Tier 3 is a mutual fund window or self-directed brokerage with a wide selection of funds and securities. It is anticipated that only a tiny fraction of the employee base is equipped or motivated to use this tier.
The starting point for avoiding these common TDF mistakes is using real participant data rather than making assumptions. Sponsors should make sure their managers are working with tools capable of scenario and stress testing. They can also forsake unworkable straight-line and stair-step glide paths in favour of models that accurately meet employees’ needs. Above all, sponsors must think about designing their investment offerings in a three-tier fashion that accurately reflects the ability and motivation of employees to manage their portfolios.
Peter Chiappinelli is senior vice-president, investment strategy and asset allocation at Pyramis Global Advisors, a Fidelity Investments Company.
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© Copyright 2009 Rogers Publishing Ltd. This article first appeared in the April 2009 edition of BENEFITS CANADA magazine.