Wednesday, October 18, 2006

Target Retirement Funds - Prefab vs. Home Brew; Ford Motor Co Study

The Pension Protection Act of 2006 will create a new paradigm in the investment profile of participant directed plans. Target Retirement Funds(TRF’s) are beginning an inevitable and rational (simply selected, diversified portfolios which are constantly monitored and consistently rebalanced while providing a fiduciary safe harbor) march to dominate 401(k) plan investment allocations. Several recent articles stimulated our thinking on alternative TRF implementations.
An article in Investment News indicated some advisers are urging employers to create their own customized TRF’s by using the population of funds available in the plan. Alleged benefits of the "home brew" from the advisors perspective were better information and control over the asset allocation and individual funds in the mix. This leads to a carefully unstated but strongly implied promise of better performance than the pre-fabricated TRF”S offered by proprietary providers which could be populated with the “mid level funds..put there by managers who are eager to generate assets in a fund that might be struggling” according to the article

While we don’t necessarily take exception to the notion that the pre-fab TRF’s are designed to meet both their sponsors economic objectives as well as their clients investment goals, we suspect there are probably not that many plans where the customized TRF solutions based on their existing fund lineup would both; have an inherent expected performance advantage and the “expected” excess returns would out-weight the added expense and liability that the sponsors would bear in creating it. We think this is so because; most plan investment menus are limited and fund selection is often driven by standards other than portfolio optimization, active management of individual fund choices is counterproductive and has a long tail in 401k plans and plan fee structures are often similar between prefabs and across investment menus.

Limited Investments (Asset Class) Options - The average 401(k) plan investment choices do not generally span the efficient frontier and are predominated by large cap equity funds which have the lowest statistical probability of outperforming their benchmarks. In addition, the ERISA suitability standard, as generally interpreted in practice, limits many investment line-ups to “core” investments. Institutionally driven TRF asset allocations should, under the principles of modern portfolio theory, include a broad array of asset classes, some of which might be deemed unsuitable and present fiduciary exposure on a stand-alone basis. Real estate is a good example of an asset class that is broadly used in institutional strategic asset allocation practices but is fairly limited in 401(k) plan line-ups.

Advisor Added Value by Active "Control"
The promise that advisors can optimize TRF return performance by actively managing the individual fund holdings within a TRF mix is largely illusory. Other than for the short term persistence inherent in some momentum strategies, fund performance is largely related to asset class exposure and accident. In addition, the process required to remove or add funds within a 401(k) plan has a fairly long horizon due to the various layers of authorization and communication which must happen before fund changes are implemented.

Investment Fees are not proportional to Plan size
The 401(k) fee industry fee structure is asymmetric in favor of providers. Fees can go up to ensure provider profitability for smaller plans but fees often don’t go below the level of fees (profitability/revenue sharing) implicit in mutual fund structures. Larger plans should enjoy economies of scale in investment fees. However, the predominant use of registered mutual funds, which often only have several price classes, limits the scale economics that many plans could take advantage of. Plans that use lower priced trusts or that have broad index fund coverage in their plans may be able to take advantage of the this via a customized TRF vs. certain prefab TRF’s.

We noticed that the Ford Motor Co 401(k) plan recently announced some 401(K) fund changes. To provide an anecdotal ex post example of the performance differential between a prefab TRF and a similarly constructed customized fund, we used the Ford Motor Co. 401(k) Plan as an example. We obtained a list of the investments in Ford’s 401(K) Plan at We did limited due diligence on the holding list and concluded it was reasonably current, though it did not reflect the recently announced fund changes.

We took the asset allocation of the Fidelity 2040 Freedom Fund as of 9/30/2006 (selected for its predominant equity allocation) as implied by the Morningstar category of each of the funds held within the Freedom Fund, and built 3 portfolio composites (rebalanced quarterly) with this static asset allocation. Historical return results are posted below.

FREEDOM 2040 STATIC – a composite using the Fidelity funds held within this fund of funds as of 9/30/2006. To create a 5 year history, we used an appropriate index return series to fill the gap for those funds with less than a 5 year track record.

FORD 401k – a composite using the actively managed funds within the Ford 401k plan in the same allocation as the Freedom 2040 static using Morningstar categories. Since Ford had no mid-cap funds, the mid cap allocation was split on a market weighted basis between Fords small & large cap equity funds. Real estate was excluded since this asset class wasn’t represented in the Freedom 2040.

FORD 401K BM a composite representing the asset allocation implicit in the Freedom 2040 Static using appropriate benchmark indicies for each asset class and style

Though purists can quibble about the details, the results of this example align with our intuition that a composite of carefully and specifically selected actively managed individual funds available in a 401(k) plan would not seem to have a distinct performance advantage over an exclusively actively managed and similarly carefully selected prefab TRF or for that matter an index based TRF. There may be some justification to the argument that having funds from the same provider in both TRF’s leads to this result. One could argue more broadly however, that systematic excess return in any diversified portfolio of actively managed funds should be similar over time since alpha by nature should be uncorrelated. We'll leave the conclusion about the sign of the expected excess return for another time.

Annualized Return through September 2006

Portfolio1 Qtr1 Yr2 Yr 3 Yr4 Yr5 Yr
Ford 401K2.8%10.2%12.3%12.2%15.6%9.1%
Freedom 2040 Static3.2%10.1%13.4%13.3%16.4%9.8%
Ford 401k Benchmark4.3%10.6%13.2%13.6%16.7%9.6%

Calendar Year Returns September 2006

Ford 401K6.0%8.6%10.3%31.9%-16.8-7.1%
Freedom 2040 Static6.2%9.8%12.1%31.1%-17.1%-10.3
Ford 401k Benchmark8.0%7.7%12.8%31.5%-17.8-10.9



Blogger ScottyD said...

While I think I see where you are coming from on this point, I would argue that the "home brew" concotion would be superior than the pre-fabs. I've studied the available Target Date funds and find them lacking. Some are well diversified but expensive (fidelity - though not nearly as expensive as others), others are cheap but not well diversified (Vanguard). It makes much more sense to build a customized target date for a plan because then the plan is in control of the risk exposure and the fees. I think your point is that many advisors to plans (which may be the fund company running the plan) will act imprudently and in their interest, not the participants. I am looking at this from the point of view of what can I as a plan sponsor (or a fiduciary of a plan sponsor) do to ensure the participants get the best allocations for the lowest cost. Thus, I am in favor of the "home brew" until someone can come out with a target date that works better.

Thu Oct 19, 10:40:00 AM 2006  

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