To Benchmark or Not to Benchmark

By Jessica Marquez

Oct. 7, 2008

Target-date funds have become the darling of the 401(k) industry because they are so easy for plan participants to understand and use.

But many plans sponsors are learning that what may appear simple and clear-cut for plan participants is actually incredibly complex for fiduciaries to oversee.

Proponents of these funds, which automatically move from an aggressive to conservative asset allocation as the investor ages, say they fight the problem of investing inertia. Employers can automatically enroll participants into these funds and they never have to do anything. Fifty percent of plan sponsors that automatically enroll employees into their 401(k) plans default them into target-date funds, according to Watson Wyatt Worldwide.

And target-date funds are incredibly easy to understand, proponents say. For example, a target-date 2040 fund is designed for employees who plan to retire that year.

But employers and their consultants are wrestling with how to gauge the performance of these funds. Given the recent market volatility, the pressure to monitor performance is more intense than ever. A number of companies, such as Dow Jones, Morningstar and Standard & Poor’s, have launched or are developing target-date indexes employers can use to compare the performance of the target-date funds in their plans.

“Plan sponsors and consultants really need to have a neutral, objective and transparent benchmark that enables them to hold their providers to,” says David Krein, senior director of institutional markets for Dow Jones Indexes, which has two target-date fund indexes.

But not everyone is convinced that it makes sense for employers to use benchmarks with target-date funds because there are so many variables.

“Managers would argue that the benchmarks might not be representative of their strategy. For example, let’s say the benchmark doesn’t include Treasury inflation-protected securities, but the target-date fund does,” says Lori Lucas, defined-contribution practice leader at Callan Associates, a San Francisco-based consultant.

Since these funds change asset allocation constantly, it’s difficult to know whether a fund has outperformed its benchmark during a given time due to its asset allocation or managerial skills, experts say.

“Benchmarking target-date funds is a huge challenge for plan sponsors, but it’s critical that they figure out how to do it right,” Lucas says. “We believe that the majority of defined-contribution plan assets will end up in target-date funds.”

Standard benchmarking approach
Traditionally, plan sponsors use third-party benchmarks to gauge the performance of the mutual funds in their 401(k) plans. For example, a company could compare the performance of a large-cap growth fund with the Standard & Poor’s 500 Index.

But since target-date funds invest in a slew of asset classes and have a moving asset allocation, it hasn’t been clear how companies should benchmark their performance. As a result, many companies were just measuring the performance of the underlying funds that make up their target-date funds against their appropriate benchmarks.

But now, with so many target-date fund indexes in development, plan sponsors are wondering how to choose which one is best for them, experts say.

“A year ago the topic on everybody’s conference agenda was, ‘How do you benchmark these funds when there are no benchmarks?’ ” says Joe Nagenast, co-founder of Target Date Analytics, a year-old company that offers four series of target-date benchmarks. “Now the story is that there are several suitable benchmarks out there, and plan sponsors need to decide which to use.”

Dow Jones came out with the first target-date indexes in 2005. These indexes, however, only take into account stocks, bonds and cash, reflecting the trends in target-date fund holdings at the time.

But in February, the New York-based company launched the Dow Jones Real Return Target Date Indexes, which take into account other asset classes included in target-date funds, such as real estate, commodities and inflation-linked bonds, Krein says.

Having benchmarks is a critical piece in getting target-date fund managers to understand what performance they should be hitting, he says.

“It doesn’t mean the managers have to follow the index,” Krein says. “But it’s a way of saying, ‘This is the standard you are being held to.’ “

He argues that benchmarks are the best way to gauge performance of target-date funds because they are transparent and objective.

Plan sponsors opting to use benchmarking will soon have more options. Standard & Poor’s and Morningstar both plan to launch target-date fund indexes in the next few months, according to officials at the companies.

And they may not be alone, observers say.

“There are a lot of indexes in development,” says Callan Associates’ Lucas.

To determine the appropriate benchmark, plan sponsors need to understand how the indexes take into account issues such as asset allocation, managerial skills and the needs of the participants, experts say.

It can be extremely difficult, but if nothing else, plan sponsors need to make sure they get beyond the marketing talk, Nagenast says.

“Companies need to make sure they understand the fundamentals behind the index,” he says.

Beyond benchmarking
Despite the growing number of available target-date fund indexes, many 401(k) consultants feel that fiduciaries need a more holistic approach to evaluating the performance of their target-date funds.

Just picking an index to benchmark the performance of the funds in a company’s plan doesn’t take into account the goals of the plan and the needs of participants, says Don Stone, president of Plan Sponsor Advisors, a Chicago-based 401(k) consultant.

“Plan sponsors need to look at what they are trying to do with these funds,” he says.

A company with an older employee population may want a different kind of target-date fund series that accepts less risk than another company.

Also, target-date funds are changing rapidly in terms of their holdings, Stone says. Five years ago it was virtually unheard of for these funds to invest in anything other than stocks and bonds. Today, many include real estate, Treasury Inflation-Protected Securities and alternative investments.

“These funds are changing as we speak, but the benchmarks are static,” he says.

Still, Stone opts to gauge the performance of target-date funds by looking at their peer groups. Through this approach, Stone studies all target-date funds in a series, such as all of the 2020 funds, and determines the median performance.

“At least then we get a median allocation and performance to work from,” he says.

But Krein argues that peer groups don’t have the same kind of transparency that third-party indexes have.

“Indexes avoid the trap where an advisor assembles a peer group and it becomes an insular process where the plan sponsor only knows the peer group returns,” he says. “They don’t know what makes up the peer group, what the risk exposure is and what the asset classes are. It’s just an opaque mechanism for benchmarking the manager.”

Nagenast argues that peer groups don’t prove much since so many target-date funds have inherent issues, such as being too aggressive or not properly suiting their investors’ needs.

“If you are just comparing against everyone else, you might look fine but you are ignoring the potential for improvement,” he says.

As more providers offer indexes, they can play a part in plan sponsors’ reviews of their target-date funds. But given the complexity of these products, most consultants suggest taking a more holistic approach to reviewing performance.

This requires digging into the “glide path,” or how the asset allocation of the funds shifts, as well as understanding the needs of the participants.

“At least by looking at the peer group, a plan sponsor can put a stake in the ground and say, ‘Here is what the performance should look like,’ ” Lucas says.

As target-date funds continue to evolve, plan sponsors will have to continually ask themselves if their performance review process is right, she says.

“This is really challenging, and as these funds continue to develop, we think it’s only going to become more challenging,” Lucas says.

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