Monday, September 12, 2016

Understanding Custom vs. Proprietary Target Date Funds

Target date funds (TDFs) are characterized as either proprietary or custom. The U.S. Department of Labor encourages plan fiduciaries to consider a custom solution. Custom TDFs are typically offered in separate account or collective trust vehicles. These vehicles are not registered as investment companies under the Investment Company Act of 1940 and therefore are precluded from use in 403(b) plans. Proprietary TDFs are defined as pre‐packaged investments that usually are comprised of underlying mutual funds of a single investment firm. Therefore, it can be challenging to ensure “best in class” managers are offered across the underlying funds within the proprietary TDF.

Morningstar, Inc., a leading investment analysis firm, considers it a best practice for target date managers to continually assess the stand-alone merit of each underlying fund used within their target-date series. Custom TDFs are created by the retirement plan sponsor, who ultimately becomes responsible for choosing the asset classes, underlying mutual funds, and the retirement savings “glide path.”

Plan sponsors who choose to implement custom TDFs generally do so in an attempt to realize investment economies of scale. One way to reduce investment expenses is to negotiate a low-cost separate account structure with an investment manager. The other main reason plan fiduciaries may implement a custom TDF is to better address the unique demographic profile of their participants. For example, a plan sponsor might consider custom TDFs when their plan has an earlier than “normal” retirement age of 65 or 67, or offers a defined benefit plan alongside the defined contribution plan. In both examples, participants may benefit from a glide path that is more aggressive than that offered by a proprietary TDF.

Plan sponsors who create custom TDFs face significant challenges:
1.    Substantial target date resources and investment expertise are required to make prudent decisions about asset classes, asset allocation, and glide path management. Sponsors who do not have such internal expertise must hire investment professionals.
2.    Complex administration and demanding participant reporting requirements. All participant educational materials, disclosures and performance calculations must be customized.
3.    Need for strong, consistent oversight of underlying investments.
4.    Recordkeeping platforms may not be able to accommodate custom TDFs.
5.    It becomes difficult to implement tactical asset allocation (shortterm overweights and underweights of assets classes).

Because of these challenges, custom TDFs are more often found in “Mega Plans” ($500 million+), as these plans have greater internal resources and expertise to take on the added complexity of customization, and they can realize economies of scale.

A truly custom strategy utilizing open architecture (best‐in‐class mutual funds from multiple companies) will likely be complicated and expensive to implement. Therefore, plan sponsors with a unique demographic participant profile should attempt to find a good fit among the 50+ proprietary TDF providers before attempting to create a custom solution. Some retirement planning experts argue that identifying an “average” participant demographic is elusive for most plans and the only way to factor in an individual’s unique circumstances would be to customize a glide path at the participant level, not the plan level. A custom glide path at the participant level is currently available through managed accounts for an additional fee.

Read 4 Steps to Building an Optimal Retirement Plan Lineup for Participants and download the Fiduciary Checklist for Target Date Fund Decisions to learn more. If you have any questions, or would like to begin talking to a retirement plan advisor, please get in touch by calling (800) 388-1963 or e-mail us at hbs@hanys.org.