Choosing a target date strategy: Weighing off-the-shelf vs. recordkeeping platform models - J.P. Morgan Asset Management
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Choosing a target date strategy: Weighing off-the-shelf vs. recordkeeping platform models

Contributors Dan Notto, Daniel Oldroyd
In Brief
  • Financial advisors who consider the recordkeeping platform model for their clients’ target date strategies may underestimate the challenges the model presents. Substantial resources and expertise are required to evaluate the model’s available glide paths and asset allocation, and to select underlying investment managers. All these critical elements must meet fiduciary standards.
  • Both off-the-shelf strategies and recordkeeping platform models offer professionally managed, well-diversified multi-asset solutions for a wide range of defined contribution (DC) plans and participants. They can be highly effective tools to help plan participants reach their retirement goals.
  • An off-the-shelf strategy, the traditional target date approach, may present the better choice. An off-the-shelf strategy can provide tactical asset allocation and allow for portability, but the models are not portable and often do not offer tactical asset allocation. In addition, the underlying investments in the models are typically limited to those on the plan’s menu; this usually precludes the use of extended asset classes. Finally, it can be much more difficult to measure and communicate performance in a platform model when compared with an off-the-shelf strategy.

Financial advisors and plan sponsors face complex choices when they select target date strategies for defined contribution plans. The first choice is foundational and in some ways the most important: an off-the-shelf or a custom target date strategy?

In an off-the-shelf target date strategy, the traditional approach, an investment manager sets overall asset allocation, establishes the glide path (the change in asset allocation as the target date fund, or TDF, gets closer to its end date), selects underlying managers and, in some cases, deploys tactical asset allocation, making measured, opportunistic shifts in asset weightings. With a few exceptions, off-the-shelf target date solutions are also known as proprietary strategies because they include the proprietary funds of the target date provider.

Although there are many varieties of custom target date strategies, they generally fall into one of two categories: complete customization or the recordkeeping platform model. For the completely customized approach, a plan sponsor hires a portfolio management team to design and manage a plan’s glide path. The plan sponsor either selects the underlying managers itself or outsources the decision. The recordkeeper or custodian handles cash flows and portfolio rebalancing. (For further analysis of complete customization, see our white paper "Custom or off-the-shelf target date strategies?" ) In the typical scenario for a recordkeeping platform model, a plan sponsor—usually following the lead of a financial advisor—selects a custom target date glide path from among the choices on a recordkeeping platform, which may range from conservative to aggressive in risk profile. The advisor evaluates overall asset allocation (usually set by the recordkeeper or a third-party entity) to determine which glide path model may be most suitable for the plan; the advisor then selects underlying managers, typically drawing on the manager roster in a plan’s existing DC lineup.

In the following pages, we examine the elements of a target date strategy and consider the choice between off-the-shelf and recordkeeping platform models (EXHIBIT 1). Financial advisors, we conclude, may not appreciate how much decision-making and responsibility they take on when they recommend a recordkeeping platform model—and thus may underestimate the challenges they could face.

Financial advisors must assess a wide range of issues in selecting a target date strategy

EXHIBIT 1: KEY CHARACTERISTICS OF OFF-THE-SHELF VS. RECORDKEEPING PLATFORM MODELS

Target date choices and the importance of diversification

In a target date strategy, participant assets are invested in a portfolio whose asset allocation reflects the participant’s investment time horizon; the fund’s glide path, which changes with a participant’s age, determines the appropriate asset mix.

Achieving effective diversification—determining which asset classes to include, based on the strategy’s risk profile—is an important responsibility for anyone designing a target date portfolio, whether it is an off-the-shelf strategy or one developed using a recordkeeping platform model. Diversification is especially important today, as investors should expect more-muted returns in the coming decades. The 2017 edition of J.P. Morgan Asset Management’s Long-Term Capital Market Assumptions (LTCMAs) anticipates that a 60% world equity and 40% U.S. aggregate bond portfolio will deliver an annual return of around 5.5% to 6.0% over a 10- to 15-year horizon, down roughly 75 basis points from our 2016 LTCMAs.

Diversification means more than simply adding a wide range of asset classes. Capturing return efficiency requires a comprehensive screening process to analyze which asset classes make sense for a particular strategy. Asset class weighting is important: A target date manager will assess what role the asset class plays in the portfolio and what level of exposure to the asset class is needed to influence the overall portfolio at each stage of the glide path.

Finally, effective diversification can enable a target date strategy to balance out risks at every point along the glide path. Key risks include longevity risk, market risk, interest rate risk and inflation risk.

Manager selection

Once the asset allocation is set, underlying investment strategies are chosen for each asset class “bucket.” (In the recordkeeping model, the advisor typically makes the choices, whereas the target date manager makes the selections in an off-the-shelf strategy.) In constructing a target date portfolio, effective managers often deploy risk budgeting—that is, they consider how much active risk an investment manager is comfortable taking in a given asset class and how to “spend” that risk with underlying strategies.

When the pieces all fall into place—the glide path, asset allocation and manager selection—target date strategies (off-the-shelf or the recordkeeping platform model) can deliver professionally managed, well-diversified multi-asset solutions for a wide range of DC plans and participants. The process may seem simple, but it’s not.

Challenges of using a recordkeeping platform model vs. off-the-shelf TDF

Recommending an off-the-shelf target date strategy is the chosen course of most financial advisors, but some also contemplate the platform model approach. For those who do, we highlight a few issues and challenges. (For a list of relevant questions, see “Considering the recordkeeping platform model: What financial advisors need to know.”)

Considering the recordkeeping platform model: What financial advisors need to know

Fiduciary responsibility and performance measurement

We begin, in a sense, at the end: Whichever target date strategy they ultimately recommend for their clients’ DC plans, financial advisors must fulfill their responsibility as fiduciaries. Whether they opt for an off-the-shelf or a recordkeeping platform model, they must be able to judge whether the strategy can help further the goals of the plan as they are articulated by the plan sponsor. For example, if the chief goal is to provide the largest number of employees with the greatest chance of maintaining living standards in retirement, can the strategy help deliver toward that goal?

Importantly, when financial advisors build a plan sponsor’s target date portfolio using a recordkeeping platform model, they assume a specific level of fiduciary responsibility: Advisors must meet fiduciary standards set forth in the Employee Retirement Income Security Act (ERISA). Among other obligations, ERISA essentially requires a fiduciary to act with the same level of care and skill that an expert would use.

When financial advisors contemplate using recordkeeping platform models, they must decide whether they are willing and able to take on that particular level of fiduciary responsibility. In addition, advisors should understand that substantial resources and expertise are required to follow the platform model’s glide path, evaluate asset allocation and select and monitor the underlying investment managers. In off-the-shelf strategies, it’s the investment managers—with their well-staffed, full-time teams of portfolio managers, researchers and market strategists—who take on those duties.

Financial advisors may not appreciate how much decision-making and responsibility they take on when they recommend a recordkeeping platform model— and thus may underestimate the challenges they could face.

 

In determining the potential of a platform model strategy, advisors need to examine the provider’s track record (including, we would argue, paying close attention to how the strategy performed in the financial crisis). However, it can be more difficult to measure performance in a platform model vs. an off-the-shelf strategy. To evaluate a model’s track record, an advisor may wish to study unitized performance data (for example, one-, three- and five-year returns) for each target date vintage; these then can be compared with an appropriate industry benchmark. But while the underlying funds in a target date model may have a track record, the target date vintage itself usually will not, because it is essentially created from scratch (often drawing on the plan sponsor’s core menu lineup). If, for example, a five-year return of a given vintage is constructed based on the performance of the underlying funds, in some instances it could be a “static” return—reflecting underlying fund performance but not the target date vintage over the prior five years as it was moving down the glide path. As a result, independent research firms, such as Morningstar, do not rate or rank platform model target date strategies. This, in turn, makes it very difficult to determine how a particular strategy measures up against a peer group or the plan’s goals.

Tactical asset allocation, extended asset classes and manager selection

Beyond the basic issue of fiduciary responsibility, a variety of factors must be taken into account in choosing between off-the-shelf and platform model strategies. Tactical asset allocation is one important consideration. Off-the-shelf strategies can utilize tactical asset allocation—that is, they can make calculated, short-term shifts in asset weightings as market opportunities present themselves. Many off-the-shelf managers choose not to use tactical asset allocation, although we believe it can provide a benefit to plan participants when it is thoughtfully executed by an experienced team. On the other hand, the operational challenges of making shorter-term shifts mean that very few, if any, recordkeeping platform models can employ tactical asset allocation. And while some of the best off-the-shelf strategies include extended asset classes (such as real estate, Treasury Inflation-Protected Securities [TIPS] and commodities) along with the foundational asset classes (equities, fixed income, cash), that wider opportunity set may not be available on platform models. Often this is because platform model strategies can use only asset classes that are already part of a plan’s core menu. In our view, this is a notable constraint. We have found that extended asset classes can be a valuable source of attractive risk-adjusted returns, especially in volatile, lower-return market environments. Recordkeeping platform models may also restrict the number of managers that can be included in their target date strategies.

Portability, participant communication and fees

Both financial advisors and plan sponsors should take portability issues into account when choosing a target date strategy. A plan sponsor using the platform model cannot change recordkeepers without also changing the target date strategy. Off-the-shelf strategies, on the other hand, are portable from one recordkeeper to another.

When it comes to fees (an increasingly top-of-mind subject), platform model strategies typically have no fee advantage when compared with their off-the-shelf counterparts. That is because disaggregation of costs can make custom strategies more expensive. As a result, financial advisors need to be careful not to “load up” on passively managed investment options for the sole purpose of holding down overall fees. Selecting any strategy for an asset allocation portfolio—whether active or passive—demands a sound due diligence process. An advisor cannot avoid this requirement by choosing an index fund.

Finally, effective plan participant communication is critical when implementing any target date strategy. Participants in an off-the-shelf strategy can access relevant information about their investments on fund company websites, and some off-the-shelf providers make available employee communication materials to help participants better understand their target date funds. In contrast, participants in a platform model may have only one source of information about their retirement funds: the communications they receive from their plan sponsor.

Conclusion

All target date strategies—off-the-shelf, complete customization and the recordkeeping platform model—can harness the power of professional investment management and age-appropriate asset class diversification. Financial advisors considering the recordkeeping platform model need to fully understand the challenge that goes with it. It is no simple task to ensure that the model lives up to its potential. While there is no “one size fits all” solution for plan sponsors, we believe that off-the-shelf target date strategies offer a highly effective tool to help plan participants reach their retirement goals.

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TARGET DATE FUNDS: Target date funds are funds with the target date being the approximate date when investors plan to start withdrawing their money. Generally, the asset allocation of each fund will change on an annual basis with the asset allocation becoming more conservative as the fund nears the target retirement date. The principal value of the fund(s) is not guaranteed at any time, including at the target date.