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Raising the Bar on Target Date Due Diligence

September 10, 2013

by Manning & Napier/Strategic Insight

of Manning & Napier


Deeming whether target date fund investments are appropriate for a specific participant population is an arduous and imperfect task, made more complicated by a lack of full transparency. Fiduciaries should question whether the underlying securities of target date funds are appropriate to meet the retirement saving needs of plan participants. However, the question itself raises concern about what it would take to examine the funds in such detail.

Regardless of this complexity, investment option due diligence is a fiduciary responsibility that must be carried out to ensure that assets are managed prudently for the benefit of plan participants. The basic tenets of this obligation, in particular as it relates to the examination of qualified default investment alternatives (QDIAs), may not be properly achieved without transparency. The goal of this paper is to introduce ideas about how transparency of target date portfolio construction can be improved.


Over the past several years, the use of automatic enrollment has increased significantly across defined contribution plans with the aim of resolving participant inertia. Currently, four out of ten defined contribution plan sponsors automatically enroll their participants.1 This growth was enabled by the Pension Protection Act of 2006, which provided a safe harbor for plan fiduciaries automatically investing participant assets in certain types of default investment alternatives in the absence of participants directing their own investments.

Three main types of QDIAs were identified by the Department of Labor (DOL): 1) life cycle or target retirement date fund; 2) balanced fund; and 3) professionally managed account. Of these three types, target date funds have emerged as the dominant QDIA selected by plan sponsors.

The DOL set forth basic requirements for implementing automatic enrollment:

• “A QDIA may not impose financial penalties or otherwise restrict the ability of a participant or beneficiary to transfer the investment from the QDIA to any other investment alternative available under the plan.”

• “A QDIA must be either managed by an investment manager, or by an investment company registered under the Investment Company Act of 1940.”

• “A QDIA must be diversified so as to minimize the risk of large losses.”

• “A QDIA may not invest participant contributions directly in employer securities.”

Since these requirements were first drafted, there has been increased scrutiny by regulatory bodies. Recently, the DOL and Securities and Exchange Commission (SEC) issued communication that discusses the importance of diversification in an investment portfolio.

Both agencies caution that choosing an asset allocation model may not be enough to diversify a portfolio, and emphasize the importance of understanding how distinct investments will perform under different market conditions. This underscores the importance of transparency with respect to the vehicle selected for the QDIA role in a plan.

As of year-end 2012, assets in U.S. target date strategies stood at more than $700 billion across mutual funds, collective investment trust funds, and custom fund structures. Across vehicles, target date strategies may surpass $1.5 trillion within the next decade. Such significant projected growth may be a driving force behind recent regulatory emphasis regarding additional disclosure, as these investments could very well become the predominant source of financial stability in retirement for millions of retirement plan participants.


The DOL advises that fiduciaries monitor service providers in ‘reasonable intervals’. The most common interval that plan sponsors review investment options is quarterly. The DOL’s framework for reviewing service providers focuses on their compensation and fees, performance, policies and practices, and any participant complaints against the provider.

Asset managers are service providers with fiduciary responsibility, whether that fiduciary responsibility comes under ERISA or the Investment Company Act. As a result, selecting and monitoring investment options, and their managers, is a fiduciary responsibility and employers have to document this process. This basic framework for review is often incorporated in a plan’s Investment Policy Statement (IPS) in varying levels of detail.

In 2010, 56% of plan sponsors had a written IPS; while that number is now up to 74%, there is still room for improvement.1 In addition to establishing the roles and responsibilities of the plan fiduciaries, the IPS may also establish a prudent process for which investment alternatives (including the QDIA) are selected, monitored, added, or changed.

A well drafted IPS would provide enough latitude to perform in-depth analysis of the investment options, but also avoid excessively stringent performance guidelines on investment alternative additions, changes, or removals.

Fiduciary best practices also include periodic interviews with the various asset managers selected for plan options. This level of in-person due diligence may enhance the fiduciary’s ability to make a qualitative assessment of a manager’s approach and portfolio positioning. In addition, regular, well-documented dialogue serves 1) to demonstrate ongoing monitoring of performance drivers; 2) to better examine whether a stated investment approach is consistently applied by the manager; and 3) to help manage plan failure risk, defined as the risk that a plan will fail to further plan sponsor objectives of achieving participant outcomes.

Common criteria used to evaluate core menu investment alternatives include fees, style consistency, diversification, performance, management, and organization, among several other factors. Each of these general criteria can be assessed using a number of different metrics, as outlined in the table at the top of the next page.



The above metrics can be applied on a comparative basis with relative ease across core asset classes such as U.S. equity, international equity, and fixed income. However, it should be noted that many of the fund scoring tools that assign a value for all or some of these measures are often limited to trailing time period data and are only one part of the overall fiduciary evaluation process.

The same framework for evaluation of target date funds is sub-optimal. While many of these metrics generally apply, the evaluation or scoring process becomes more complex given that target date funds encompass multiple asset classes. Furthermore, their dynamic nature may lend to greater variance within the strategy type than experienced with core menu options. Subsequently, there are a number of additional metrics that can be considered when evaluating a QDIA, particularly a target date fund.

In February 2013, the DOL released additional guidance for fiduciaries to follow in regards to target date fund screening and monitoring. The guideline that may pose the most significant challenge to fiduciaries in target date fund selection is #3 – “Understand the fund’s investments…and how these will change over time.” Criteria such as performance, fees, management, and organization continue to be critically important. However, it is integral for the fiduciary to understand overall portfolio construction and underlying vehicles along with the glidepath to determine whether the investment process is prudent.




The majority (81%) of plan sponsors believe that they have a fiduciary responsibility to evaluate the underlying investments in target date funds.2 However, truly understanding a target date fund’s underlying investments and how those investments change over time can be a challenge for plan fiduciaries. Even with standardized reporting and available disclosure through regulatory filings or other sources, target date products are still difficult to compare on a side-by-side basis due to differences in the investment process, underlying investment vehicles, portfolio construction, and glidepath. Relative to core fund options, screening criteria for target date funds must include an effort to understand each fund’s investments and how they change over time, as noted by the DOL.


This paper highlights the following three key considerations for fiduciaries during their target date due diligence process regarding underlying investment vehicles:

1. Transparency of the Portfolio Structure

2. Portfolio Management Coordination

3. Potential Over-diversification


The majority of target date funds adopted by fiduciaries as QDIAs are fund-of-funds products. Fund-of-funds generally only provide transparency regarding the underlying funds, versus disclosing the aggregated securities composition. For example, we identified only two target date mutual fund managers that provided Morningstar with the total number of holdings in terms of underlying securities. The remaining target date managers share the number of underlying funds, meaning that most of these products are translucent, at best, relative to holdings disclosure.

The void in full holdings disclosure of target date funds extends beyond reporting to data vendors. Disclosure of ‘holdings’ found in target date fund marketing materials, filings, and websites generally refers to broad asset classes or underlying funds.

Peeling back this layer is not currently required by the SEC nor is it part of the SEC/DOL proposal on enhancing target date disclosure (although the latter does focus on the number and type of asset classes portrayed in the glidepath chart and in allocation tables). It should be noted, however, that the SEC/DOL has requested comment on such detailed holdings disclosure.

This lack of comparable and complete disclosure complicates, if not obfuscates, detailed analysis by fiduciaries. In its Fiduciary Guidebook for Target Date Funds, released in February 2013, The Wagner Law Group highlights that the “fund- of-funds’ structure of TDFs (target date funds) presents special challenges for fiduciary reviews.”

By only providing high level information on the underlying funds, most target date providers leave fiduciaries and investors uncertain what the target date portfolio actually holds, especially when the target date fund utilizes a large number of underlying mutual funds. While target date managers not providing securities-level disclosure may provide such detail “on request”, few plan sponsors, advisors, and investors have the time and resources to keep digging. Thorough analysis of underlying holdings and securities concentration requires full lists of holdings from a data vendor such as Morningstar, or from the SEC’s Form N-Q, followed by diligent data aggregation and manipulation.

Since current underlying fund level disclosure may be insufficient when conducting target date due diligence in order to meet fiduciary obligations, the question is, what information can be requested by plan sponsors and advisors to ensure some level of transparency to the underlying holdings as they complete their target date fund due diligence?

To better meet fiduciary obligations, plan sponsors and advisors can request target date fund manager candidates to report the total number of underlying holdings for each target date fund, alongside the number of distinct holdings in each target date fund. The latter point recognizes that target date funds that utilize a fund-of-funds approach may hold the same security in more than one underlying fund.

Armed with this level of information about a target date fund, a plan sponsor or advisor will be better equipped to address each of the next two points for consideration: portfolio management coordination and the potential for over-diversification.


Target date funds have, on average, approximately 15 underlying mutual funds. While some have as few as one, others have as many as 51. These underlying funds often reflect a variety of asset classes, objectives, and strategies. Underlying funds that represent single asset classes may be purely stock or bond, real assets, or money markets. Other underlying funds that reflect investment objectives include growth, income, or growth and income funds. Additionally, underlying funds often are segmented based on regional exposure including domestic, international, emerging markets, or global.

There are various reasons for fiduciaries to examine underlying funds. Concerns have been raised that a manager may feature an underperforming or newly launched fund for business rather than investment reasons. More importantly, numerous combinations of and allocations among underlying funds often create securities overlap despite the varying asset classes, strategies, and domiciles. Among other reasons, this overlap happens because funds with different investment objectives still may invest in the same securities. Also, the asset allocation manager at the target date fund level is oftentimes different than the portfolio managers of the underlying funds. Funds with distinct mandates, but potentially overlapping holdings, may be as difficult for the asset allocation manager to coordinate, as reviewing and performing due diligence would be for the fiduciary.

On average, a single target date fund has 15 distinct portfolio managers or portfolio management teams buying and selling underlying securities. Given that, it may be worth reviewing whether a fund’s managers or teams work independently, with some picking securities within their underlying fund only, and others monitoring the total asset allocation of the target date fund. For many target date fund providers, where the underlying funds are also available for retail sale, the underlying fund portfolio managers naturally select securities independently based on their specific mandate – not the mandate of the target date fund.


The SEC mandates that “a diversified portfolio should be diversified at two levels: between asset categories and within asset categories.”3 Simply defined, diversification is investing in a variety of assets as a way to reduce risk.

It is generally accepted that the number of securities within a portfolio helps to determine a portfolio’s diversification, but little consensus exists on what is an optimal number of securities for a fully diversified portfolio (despite there being general consensus on the asset classes or sub- asset classes necessary to achieve a diversified portfolio).

Further, there is little published research that details additional diversification benefits derived through fund-of-funds approaches. However, when considering target date funds that may hold more than 5,000 securities on average, plan sponsors and advisors should consider the potential for over-diversification, as such a significant number of holdings is likely to produce index-like returns.

For plan sponsors and advisors that prefer actively managed target date funds, a target date fund’s level of active share may help to identify potential over-diversification concerns. Researchers, Cremers and Petajisto, identify active share as a measurement that “represents the share of portfolio holdings that differ from the benchmark index holdings.”4 The researchers conclude that funds with higher active share tend to be more consistent in generating high returns against their benchmark indices. While active share may help provide a more comprehensive picture of active management, the study focused solely on equity funds, and applying the active share metric to multiple asset class funds like target date funds is more difficult. Despite the complex process, applying active share to the more equity-oriented multi-asset fund-of-funds within a target date fund family may shine additional light on the efficacy and expected performance of these products.

Over-diversification has been explored on both a corporate, firm-specific level and in regards to investment portfolios. For example, an article written by David Allison, CFA® (of Allison Investment Management, LLC) suggests top signs of over-diversification may include owning too many mutual funds within any single investment style category, excessive use of multi-manager investments, and owning an excessive number of individual stock positions.5

Not all multi-manager products are over- diversified and inefficient, but plan sponsors and advisors should consider both the total number of underlying holdings for target date fund candidates, as well as the active share measure of the most equity-oriented target date fund within the family. This will help assess the potential for over-diversification across the fund family’s target date offerings, which may lead to higher transaction costs and benchmark-like returns.

As mentioned previously, this is particularly important when assessing actively managed target date funds. An important aspect of the active-versus-passive examination for a diversified portfolio involves a fiduciary assessing the approach that may best manage the risk of large losses and help participants achieve their spending goals in retirement. While passive management attempts to reduce the risk of overpaying and the risk of underperforming the market, active management intends to navigate additional risks, such as the risk of sustained capital loss or the risk of failing to keep pace with inflation. However, assessment of active management approaches need to consider the problem of over-diversification. While diversification is an important part of investing for a QDIA, a significant number of holdings is likely to produce index-like returns.


The benefits of life cycle funds in providing professionally managed asset allocation, portfolio diversification, and automatic rebalancing are highly important given the average American’s investment aptitude and his/her individual burden to accumulate sufficient retirement savings. With the focus on transparency increasing broadly across the retirement landscape, target date funds may become the next area of scrutiny as they are now the default retirement savings strategy for so many.

Full transparency on the underlying investments in a target date fund should allow plan sponsors and advisors to better perform their fiduciary duties of due diligence on target date funds at a level similar to that of more traditional core funds on the investment menu. Ultimately, this aids plan sponsors, consultants, and advisors in making more informed recommendations and QDIA selections. While current disclosure rules and reporting limitations may make this process difficult, to better address their fiduciary responsibility of QDIA due diligence, plan sponsors and advisors may benefit from requesting information from target date providers as it relates to:

• Total number of underlying holdings

• Total number of distinct holdings

• Who (specifically) is making asset allocation decisions

• Who (specifically) is making security selection decisions

• The level of active share of the target date family’s most equity-oriented fund, relative to its benchmark

While this distinction between underlying fund and underlying security may not be immediately appreciated by plan participants, they are ultimately the most important beneficiaries of such transparency.


In its February 2013 guidance, the DOL also recommends that fiduciaries “take advantage of available sources of information to evaluate the target date fund.” Information on target date funds may be obtained directly from plan administrators (recordkeepers), target date fund providers (asset managers), financial advisors, and consultants. In addition, several thoughtful, detailed, and objective research reports have emerged over the past several years that can serve as valuable reference tools for target date due diligence, including the Annual Target Date Fund Report by Morningstar.

CFA® is a trademark owned by the CFA Institute. Manning & Napier, Inc. (MN) is publicly traded under MN.

The Manning & Napier Fund, Inc. is managed by Manning & Napier Advisors, LLC (Manning & Napier). Manning & Napier Investor Services, Inc., an affiliate of Manning& Napier, is the distributor of the Fund shares. Strategic Insight is not affiliated with any of the aforementioned Manning & Napier companies.

Unless otherwise noted, data provided by Manning & Napier or Strategic Insight.

Sources: U.S. Department of Labor, U.S. Securities and Exchange Commission, The Wagner Law Group, Strategic Insight Simfund, Morningstar.

1Allsbrook, Wesley. “Looking to the Stars, 2012 PLANSPONSOR DC Survey.” November 2012. Print.

2Janus and PLANSPONSOR Magazine, A Janus Capital Group Company. “Trends in Target-Date Funds, A 2012 Survey of Defined Contribution Plan Sponsors.” January 2013. Print.

3U.S. Securities and Exchange Commission. “Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing.” Web < assetallocation.htm> August 28, 2009.

4Cremers, Martijn and Petajisto, Antti. “How Active is Your Fund Manager? A New Measure That Predicts Performance,” AFA 2007 Chicago Meetings Paper; EFA 2007 Ljubljana Meetings Paper;Yale ICF Working Paper No. 06-14. Web <> or <> March 31, 2009.

5Allison, David. “Top 4 Signs of Over-diversification.” Web < pdf?advisorid=322232> April, 2011.

SEC Proposals

The SEC proposals on target date disclosure includes changes to marketing materials in order to reduce confusion and misinterpretation by investors regarding the allocation of a fund’s assets at its target date. The proposals also require that the asset allocation of funds is communicated via both a written description and pictorial depiction in marketing materials.

Asset Allocation - Written Description: The first reference to target date fund that includes a target date in the name must disclose the asset allocation. Stating the asset allocation is intended to alert investors to the existence of investment risk associated with the fund at and after the target date. Additionally, the SEC requires that the asset allocation disclosure will highlight ‘types of investments.’ This means that a target date fund would be required to disclosure its percentage allocation to equity securities, instead of its percentage allocation to equity funds. This rule will provide greater transparency into the holdings characteristic and improved performance attribution and comparison among fund-of-fund target date funds. The SEC proposal allows for firms to disclose ranges for potential percentage allocations, as long as the ranges are not broad and the funds do not substantially deviate from the ranges.

Asset Allocation - Pictorial Depiction: Target date marketing materials must include a prominent table, chart, or graph that clearly depicts the asset allocations among types of investments over the life of the fund. The pictorial depiction must clearly depict the percentage allocations at periodic five-year intervals along the life of the fund, as well as the asset allocation at the inception date, target date, and landing point. For materials that relate to a single target date fund, the allocation as of the most recent quarter end is also required. For materials that relate to multiple target date funds within a series, two options for the pictorial depiction are allowed: either one table, chart or graph per fund; or a single depiction representing the asset allocation glidepath. If the funds’ asset allocations vary within a range, the ranges should be visible in the graphic. Also for single funds, ranges should be shown for future periods only, and historical periods are required to show the actual allocations.

Proposal would also require statements preceding the chart to include explanations that:

• The asset allocation changes over time;

• The asset allocation eventually becomes fixed at the landing point, and the number of years between the target date and the landing point;

• The percentage allocations among types of investments may be modified without a shareholder vote.

Copyright 2013 Manning & Napier and Strategic Insight, an Asset International Company, and Morningstar Inc. All rights reserved. The information, data, analyses and opinions contained herein (a) include confidential and proprietary information of the aforementioned companies, (b) may not copied or redistributed for any purpose, © are provided solely for information purposes, and (d) are not warranted or represented to be correct, complete, accurate, or timely. Past performance is no guarantee of future results. The aforementioned companies are not affiliated with each other. Reproduction in whole or in part prohibited except by permission. This report has been prepared using information and sources we believe to be reliable; however, we make no representation as to its accuracy, adequacy or completeness, nor do we assume responsibility for any errors or omissions or for any results obtained from the use of this report, including any action taken with respect to securities referred to in this report. Strategic Insight employees may from time to time acquire, hold or sell a position in securities mentioned herein.

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