27 June 2017

Tibble Ruling Impact on Target-Date Monitoring

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All 401(k) fiduciaries should be asking themselves a question now that the U.S. Supreme Court's Tibble et al. vs. Edison International decision has made it perfectly clear that no investment option, regardless of how prudently it was chosen, can be set on autopilot and forgotten. How should target-date funds be monitored? Target-date funds are complex. Selecting and monitoring target-date funds is no piece of cake. Monitoring them is quite different from monitoring stock, bond and even alternative investment funds. Those latter investment funds are used by do-it-yourself 401(k) participants to create their own asset allocations. Target-date funds are for participants who assume their plan fiduciaries select the best target-date funds available and expect professional investment managers to do all the work for them with one exception, deciding how much to contribute.

Unfortunately for fiduciaries and their consultants, the monitoring process for target-date funds is ambiguous at best. This reality shouldn't be surprising given the great variation among the asset allocations, and thus returns, of target-date funds with the same retirement date and the glidepaths of different target-date fund families. This dispersion occurs even though the goals of the various target-date fund families — the large majority of which are created by money management firms that are highly regarded and have years of experience in serving the institutional marketplace — are essentially the same: “to get the maximum number of participants to a comfortable income replacement level during retirement.”

To zero in on the likelihood that the chosen glidepath actually will provide the targeted retirement income, practically all of these investment managers run thousands, if not tens of thousands, of Monte Carlo simulations. Unfortunately, such modeling requires a slew of assumptions and inputs, such as projecting future asset class returns, riskiness and correlations.

Arriving at assumptions requires a lot of “crystal-ball gazing” and value judgments. To make matters worse, history is often a poor guide for projecting rates of return. For example, J.P. Morgan Asset Management is projecting the Standard & Poor's 500 average annual total return over the next 10 to 15 years will be 6.5% (which, given their projection for inflation, works out to a real return of 4.25%). This projected return is significantly less than the S&P 500 average annual total returns over the 10 and 30 years ended Sept. 30, 2014. For the 10-year period, the average nominal return average was 8.1%; for the 30-year period, it was 12.16%.

For the same 10- and 30-year periods, Barclays U.S. Aggregate Bond index had average annual total return of 4.62% and 8.7%, respectively, according to a report in October from J.P. Morgan Asset Management. Unfortunately, we can't always assume that stocks will outperform bonds. Sometimes the opposite happens, as illustrated by the underperformance that occurred in calendar years 1929 through 1949 as well as for the span from the end of February 1968 through February 2009, according to “Bonds: Why Bother?” by Robert Arnott, May/June 2009 Journal of Indexes.

Given the fragility of the assumptions, three obvious questions arise: How often are the assumptions underlying the glidepath, including those that lead to allocations within and among the asset classes, revised? Should the glidepath be static, as most are now described, or should it be dynamic so that it can reflect current market conditions which will enable it to capture opportunities to enhance investment returns? Unless the fiduciaries understand all the assumptions that go into creating their target-date funds, how can they justify both their initial selection and monitoring processes?

Even if the fiduciaries understand all the assumptions, they still can't monitor whether their choice of target-date funds is actually helping their employees achieve a financially secure retirement unless:

  • they routinely monitor changes in their employees' retirement readiness, including analyzing changes in the number of years their participants are projected to receive their targeted inflation-adjusted income;
  • they and their participants understand the contribution amounts that will be required to achieve their targeted income replacement ratio if the projected returns inherent in the Monte Carlo simulation results materialize (which requires knowing what those projected returns are); and
  • they ask whether their employees should be able to afford contributing at the suggested rate after reflecting their employees' current 401(k) account balances, health-care cost-shifting, etc.

Despite their complexity, target-date funds can provide a win-win proposition for participants and sponsors. For participants, target-date funds can and should be extremely efficient tools in helping achieve retirement security. For sponsors, target-date funds can help employers avoid having workforces that can't afford to retire. Prudent monitoring of target-date funds will lead to a win-win situation for all concerned. Otherwise plan sponsors risk ending up in court.

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