The Continual Drive Toward Custom Target-Date Solutions

By Jerry Bramlett • 12/3/2014 • 0 Comments

By 2019, 88% of all new contributions will go to target-date funds, according to a recent report from Cerulli (free registration required). The report also predicts that the market share of custom TDFs will steadily increase from its current level of 8%. 

A recent Morningstar report, Why Human Capital Matters to Retirement Plan Participants, bolsters that argument. The report, which is based on new Morningstar research, provides several convincing illustrations of why TDFs should be customized down to the individual participant level.

The view espoused by Morningstar is “that employers interested in improving participant outcomes should consider the non-financial assets of 
their participant base when developing custom target-date solutions.” To illustrate their point, they provide three different individual investment scenarios. The dominant factors affecting asset allocation in these examples are the industry in which each investor is employed as well as the region in which they live and their pensions. 

The hypothetical investors are:

  • Maria the stockbroker. Since Maria’s job is tied heavily to the financial services industry, she should tilt away from value stocks and toward growth stocks since the former tends to underperform when the financial markets are down.
  • Roger the radiologist. Roger lives in Las Vegas, one of the more volatile real estate markets in the country. Given his exposure to real estate investment risk, he should tilt away from REITs and small-cap value and focus more on commodities, TIPs and large-cap growth.
  • Joe the field engineer. Joe, whose job is connected to the energy sector, should tilt away from commodities, REITs and large-cap value and focus on TIPS and large-cap growth. 

No doubt, these recommended asset allocation scenarios are painted with some pretty broad strokes. However, the point is well made. In fact, the Morningstar report goes on to say that, “according to our research, using a total-wealth approach when designing target-date solutions for retirement plans can significantly change an optimal allocation, with average asset-class differences exceeding 20%.”  

Conclusion

Facing the headwinds of what many believe will be equity returns in the mid-single-digits for many years to come, any enhancement to investor outcomes that can be derived from fine tuning asset allocation programs is a welcome development.  

While wide adoption of simplified TDF asset allocation programs has greatly improved the proper investment alignment for millions of DC investors, the next step is to further refine the efficacy of these programs. The key is to do so without taking away from the simplified means of adoption that has been a major contributor to the strong growth of TDFs. 

However, customization should not add any significant complexity to investor adoption. As the conclusion of the Morningstar report attests, “Custom target-date solutions represent an option that delivers the benefit of professional investment expertise without extensive participant involvement … demographic and workforce data is readily available for plan participants, and employers should use that information to build custom target-date solutions.”

There’s little doubt that custom target-date solutions look like the next stage of evolution in the TDF industry. Plan advisors and money managers have little choice but to embrace this emerging reality — or else find a better way to improve upon one-size-fits-all TDFs. 

It’s also important that any asset allocation program be built on what is now common knowledge. The fact is, it’s very difficult to get most DC investors to engage in an effective way with anything other than the simplest of asset allocation programs.

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