February 2011

Towers Watson Comments on Target Date Fund Disclosure Proposed Regulations

By Alec Dike, Francis Grealy and Sue Walton

Target date funds are the predominant choice of fiduciaries for qualified default investment alternatives (QDIAs) in defined contribution (DC) plans and are popular with plan participants as well. Their growing popularity emphasizes the importance of encouraging fiduciaries to be prudent in selecting and monitoring target date funds and of helping participants better understand their features, design and intended operations.

Towers Watson recently submitted comments to the Department of Labor (DOL) on its proposed amendments to regulations on QDIAs and to disclosures required for participant-directed investments as they relate to target date funds. The comments address identifying assumptions in disclosures, the effective date, benchmarking and considerations for plan fiduciaries in choosing target date funds.

Proposed amendments

The DOL's proposed amendments to its participant-level disclosure regulations for target-date funds would require participant notices to disclose more specific investment-related information, including:

• The age group for which the investment is designed
• The relevance of the date in the fund's name
• Any assumptions about contribution and withdrawal intentions on or after such date
• The investment alternative's asset allocation
• How the asset allocation will change over time
• The point in time when the investment will reach its most conservative asset allocation (including a graphic representation, e.g., a chart or table that illustrates the change in asset allocation)

Similar requirements are added for the notices issued when a target date fund is used as a QDIA.

Towers Watson's suggestions

Towers Watson made the following suggestions to the DOL.

Identify assumptions in disclosures
Disclosures should identify assumptions about the participant's other investments/asset classes. This would help participants assess whether the fund is consistent with their risk profile and other retirement assets.

Change the effective date
Towers Watson recommends the final effective date be plan years beginning on or after November 1, 2011 (assuming final publication in the Federal Register at least 90 days earlier). This is consistent with both the general date for new disclosures for participant-directed investments and past effective dates for QDIA rules. Thus, calendar-year plans would need to comply with the QDIA policies for the 2012 plan year.

Modify benchmark requirements
We suggest reconsidering the ERISA section 404(a) participant disclosure regulations requirement that target date funds offer a benchmark that is a broad-based securities market index. Towers Watson believes a proportionately weighted benchmark composed of broad-based indices that is tailored to the actual or intended equity, fixed-income and other holdings of a target date fund should be sufficient. Having a single benchmark would reduce potential confusion and better support participant comparisons and analysis. Changing this requirement would acknowledge the absence of a single "broad-based" glide path and the consequent absence of a single broad-based market index for target path funds.

The DOL's preamble allows a customized, proportionally weighted benchmark to be used in addition to a broad-based index, and refers to actual asset allocations as the source of such a customized benchmark. Towers Watson believes the allocations intended under the fund's asset allocation policy should also be allowed and might be preferable. Target date funds operate through frequent but often less than constant rebalancing. Some rebalancing aims to spread investment gains and losses to restore the current glide path position, i.e., "tactical" rebalancing. Rebalancing to move a fund along a glide path could be called "strategic." Our experience is that the frequency of both tactical and strategic rebalancing varies, with possible frequencies including daily, quarterly, semiannual and annual. Target date funds that do not rebalance daily should be allowed to report performance history based on the performance of each underlying fund using the intended policy allocations.

Similarly, the appropriate benchmark should be based on the intended policy allocations using broad-based market indices. Managers that have policy discretion to allocate along their glide path or that depart from their policy raise special considerations where the underlying principle of like-to-like comparisons is especially important. Using actual benchmark weights rather than policy benchmark weights would not adequately reflect the manager's active asset allocation decisions.

As all fiduciaries might not have access to the resources needed for a proportionally weighted benchmark specific to their glide path — and some might not agree that two benchmarks for a single fund could be confusing — we suggest allowing fiduciaries to choose among three alternatives for each target date fund:

1. A broad-based market index
2. A benchmark made up of passively managed indices that are themselves broad-based, and that are used in proportional weights to actual or intended asset allocations
3. Both (1) and (2), as two separate benchmarks. Adding (2) as a choice would allow fiduciaries to offer a single benchmark for each fund and not treat a given series of target date funds differently from all other funds. At the same time, (2) requires that any glide-path-specific benchmark be composed, at an asset class level, of broad-based indices and so should meet concerns about objectivity.

Broaden the emphasis in guidance for fiduciaries
Plan fiduciaries should be encouraged to carefully consider and evaluate alternative target date fund series. The regulations focus on glide path and fees, which are very important. However, other criteria are equally important, and we look forward to continued market innovation.

In considering additional guidance for plan fiduciaries on the processes and criteria intended to support prudent selection and monitoring of target date funds, Towers Watson urges the DOL not to formulate an all-inclusive list of criteria or processes but instead focus attention on other facets of risk assessment, while also noting that, as markets evolve, new criteria will likely emerge.

A non-exclusive list would include such considerations as active versus passive strategies, the degree of alignment of underlying managers with managers of other investment menu choices, the potential for using glide paths and managers that are not affiliated with other providers, the use of alternative asset classes, and implementation strategies and tactics.

Conclusion

The increasing importance and ongoing evolution of target date funds make it important that the proposed DOL guidance on target date fund disclosure requirements be informed by the experience and perspectives of active DC plan practitioners. Towers Watson is appreciative of the opportunity to comment and will monitor future regulatory and market developments.