As defined contribution (DC) plan sponsors know, the US Department of Labor recommends considering both packaged and custom target-date strategies when choosing a solution. As we see it, packaged solutions can learn a few things from fully customized target-date solutions, which are generally used by large and megasize plan sponsors.
Selecting a target-date solution is a fiduciary act, and plan sponsors must work through the distinctions between custom and packaged approaches in order to decide which is the better fit for participants in their own plans. However, we don’t think the choice necessarily needs to be black and white.
Here are five principles that we believe can raise the bar for packaged target-date solutions:
1) Separate Asset-Allocation and Manager-Selection Decisions
A well-designed asset allocation is fundamental to an effective target-date solution. The percentages of stocks, bonds and other investments, and the glide path—how those percentages evolve through participants’ life stages—form the building blocks of a long-term investing strategy.
But it’s also important to choose the best managers to run each target-date building block, and that poses a number of questions: How has a manager performed over time? Equally important, how has a manager fared in unfriendly markets? Is a manager nimble enough to make course corrections while adhering to the firm’s investment philosophy? Does the manager complement other managers?
Not every firm has the same ability to design glide paths and choose managers. What’s more, some may choose managers who include only their proprietary strategies in the portfolio mix, rather than managers who are the best fit for each asset class. This constraint limits the asset classes that can be used. It also introduces the risk of “correlated alpha”—no manager outperforms all the time, which means that many of the underlying strategies may underperform simultaneously.
That’s why we think it makes sense to assign the asset-allocation and manager-selection roles to different providers. This brings a measure of independent thinking and reduces the potential for conflict that arises when one manager wears both hats.
2) Use a Mix of Active and Passive Management
Passive management seems to be to the “go-to” approach for many investors these days, but active management can be effective, too, offering more opportunities for alpha generation in markets such as small-cap stocks and high-yield bonds.
A target-date solution can spend its active “budget” in these areas or in other diversifying asset classes to enhance risk-adjusted returns. At the same time, cost-efficient passive exposures can be used in highly competitive markets, such as large-cap stocks, where it’s harder for active management to stand out. Using both approaches can result in an effective combination of cost-efficiency and alpha potential and facilitate a broader asset allocation, as we discuss in the next section.
3) Diversify Portfolios Beyond Stocks and Bonds
In our view, target-date solutions are best served by moving beyond the traditional “two-asset” philosophy combining growth and defensive assets. Growth assets—namely, stocks—can drive long-term growth, but today’s return expectations are lower. Defensive assets, such as high-quality bonds, may serve as an effective counterbalance, but low interest rates have little room to fall further, so bonds may be less able than usual to offset equity risk.
This conundrum highlights how important it is to upgrade asset allocations in order to manage downside risks. Building blocks that are often found in defined benefit plans—defensive equities, inflation strategies, real assets and alternative strategies—are less correlated with broad stock and bond markets. Integrating these strategies in a target-date allocation can help reduce overall risk and enhance return, which can aid in long-term wealth building.
4) Build in Tactical Flexibility to Cushion Against Downturns
Target-date glide paths are designed to gradually evolve asset allocations over time, based on an investor’s age and targeted retirement date. That means more equity exposure to drive growth for younger investors and more bonds to add stability for investors moving closer to retirement. Think of it as a pilot plotting a careful course to reach a destination.
A sound glide path is a good strategic approach to adapting to investors’ changing needs, but asset allocation also requires the flexibility to adjust to tough market conditions—making course corrections to handle pockets of turbulence. In certain market environments where volatility and downside risk have risen sharply, tactical decisions to de-risk can help reduce the damage from equity downturns—a key objective when trying to maximize the chances of retirement success.
5) Allocate for Tomorrow’s Markets, Not Yesterday’s
Markets evolve: results from the last three to five years won’t repeat themselves over the next three to five years. That’s why asset allocations need to be designed based on forward-looking capital-market views, rather than past market conditions.
There’s no reason that packaged target-date solutions can’t take a page or two from the flight plans of custom offerings. By leveraging the best practices of custom target-date design, packaged solutions have the potential to be better diversified, more sophisticated in their asset-allocation approach and more nimble in adjusting to changing market conditions.
- Jennifer DeLong
- Managing Director—Head—Defined Contribution
- Andrew Stumacher
- Managing Director—Defined Contribution