Retirement plan sponsors have a duty to screen target-date fundofferings. However, a January analysis by Janus questions ifthey're doing enough to vet the underlying funds in TDFs.

Seventy percent of the target-date funds analyzed in the reportinclude underlying managers who would fail to meet customaryinvestment policy statement (IPS) standards in at least twocategories.

“Plan fiduciaries who comply with a well-constructed IPS take animportant step toward meeting certain [Employee Retirement IncomeSecurity Act] responsibilities, including the duty of prudence,”authors Matt Sommer and Joel Evenhouse wrote. “Among other things,an IPS defines criteria that sponsors use to evaluate and, ifnecessary, replace certain underperforming managers.”

However, they claim that most plan sponsors fail to considerwhether the underlying funds in the TDFs they offer could pass thesame performance standards as the core managers.

That's important because 60% of plan sponsors believe TDFs arethe best choice for a qualified default investment alternative fortheir employees, according to a 2016 survey by Janus andPlansponsor. The largest plans are the most likely to usetarget-date funds as the QDIA; 85% of plans with more than $1billion in assets said they use the funds as the qualified default,according to the study of approximately 4,600 plan sponsors.

The report analyzed the underlying funds in the 10 largest 2040target-date funds by assets, as determined by Morningstar, to seewhat percentage of those funds would meet a sample IPS criteria. Tomeet the standards in Janus' sample IPS, the funds must be at leastfive years old, with a manager who has served at least that long,and expense ratios must be in the best 50%. One-, three- andfive-year performance must be in the top half for the fund's peergroup, and Sharpe ratios for the same periods must be at leastmedian for the peer group.

Only one TDF manager (who Janus did not name) met all of thesestandards with 75% or more of the underlying funds. In five of thetop 10 funds, less than half of underlying managers met thefive-year performance and Sharpe ratio criteria (and at one ofthose, underlying managers also failed to meet one-year andthree-year performance criteria).

Sommer and Evenhouse stressed that these results don'timmediately suggest a TDF manager is doing a bad job. “Rememberthat 94% of the variability of returns is due to the assetallocation, not security selection,” they wrote.

However, sponsors have to wonder why a manager would keep thosepoorly performing funds in the TDF instead of replacing them withsomething better able to maximize risk-adjusted goals. Janus' 2016survey of plan sponsors provides a possible answer: 41% ofsponsors, and 63% of large plan sponsors, use proprietary TDFsolutions.“The inherent conflicts of interest should be clear: Howcan Manager E possibly replace an underlying fund that is alsomanaged by his own company, especially when a superior alternativeis offered by a competitor?” Sommer and Evenhouse asked.

They suggested two possible solutions. In a model portfolioapproach, plan administrators create a set of model TDF portfoliosusing funds in the plan's core lineup. Asset allocation acrossthose funds are set by the model portfolio chosen by theparticipant.

Alternatively, a trust unitization approach establishes eachtarget-date portfolio as a separate account in a trust and as anindividual investment option on the recordkeeping system, accordingto the paper.

“In both cases, plan sponsors are able to leverage the effortalready used to select and monitor the plan's core menu,” theywrote. “This approach ensures that only managers that meet strictIPS criteria are used to build the plan's target-date funds.”

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