PROspective Vol II No VIII September 2011

Chuck Miller: Why did Standard & Poors feel Target Date Fund benchmarks were needed?

Phil Murphy: Target Date is an investment category which has enormous significance for the retirement security of American workers. At the same time, it is tremendously challenging for DC plan fiduciaries to select and monitor target date funds. S&P Indices believes that the more transparency stakeholders have when sifting through the complexity of target date strategies, the better equipped they will be to choose the right product for their needs. To provide some of that transparency, we created a target date benchmark composed of a passively implemented, consensus-driven asset allocation.

Our approach is to identify the consensus asset allocation for each target date year by conducting an annual asset allocation survey of target date funds. We use the data gathered in our survey to form the basis of our benchmark glide path, which we then implement with passive exposure to each asset class. This enables stakeholders to isolate the sources of return, and compare asset allocations, for each target date manager versus a representative market proxy.

Exhibit 1 – The S&P benchmark glide path (in orange below) is a proxy for the overall target date industry. Here it is depicted in a graph showing the glide-paths of a group of 10 large target date mutual funds.

Source: S&P Indices

CM: What are the components of the benchmarks and why were they chosen?

PM: Our index methodology specifies that for an asset class to be represented in our benchmark, it has to be present in 25% or more of the target date managers' glide-paths that we survey annually. Then we implement that exposure in the index with a liquid ETF to passively represent exposure to the asset class.

We started out with nine asset classes in our target date benchmark, driven by what we saw among managers whom we surveyed. In 2011 high yield bonds and commodities were added because they met the 25% criteria for inclusion.

Exhibit 2 – The underlying asset classes and benchmark within the S&P Target Date Index.

CM: Do the benchmarks just calculate fund returns, or do they also calculate fund risks?

PM: The benchmark facilitates a wide range of qualitative and quantitative analysis, including many risk metrics. Index levels and returns are available publicly on many data vendor platforms including Bloomberg, Reuters, MorningStar Direct, and Lipper. Any returns-based analysis, including various measures of risk and risk-adjusted returns, can be performed. Our full data package also includes index asset allocations, which enable qualitative comparisons of fund manager exposures with the benchmark, as well as attribution analysis to uncover exactly how target date managers are adding or detracting value.

CM: What have the benchmarks shown so far? What have you learned?

PM: The benchmarks provide a systematic way of tracking the asset class exposures and performance of the target date industry as a whole. They show which asset classes are predominant and what shifts take place among them over time. Lately inflation-sensitive assets have been more heavily weighted in a number of glide paths, and as others are added they will be reflected in our index if they are adopted widely enough.

Through conducting our annual asset allocation survey we have learned that target date funds are extremely complex. Not only are there moving parts within a given glide path, but across the target date universe allocations and mandates differ markedly. Fiduciaries need help in assessing which target date strategy best fits their plan.

CM: How should plan sponsors use the benchmarks?

PM: For benchmarking target date strategies, sponsors should look beyond simple performance comparisons. Unlike comparing a single asset class mandate against an appropriate index, multi-asset class mandates require a more nuanced approach in which an appropriate benchmark becomes an important tool.

For example, say a plan feels that conservatism in exposing its participants to short term market risk is appropriate for its work force. First of all, they can use the benchmark as a market reference point and compare the glide paths of particular managers to the consensus glide path of the S&P target date benchmark. This helps to qualitatively answer the question "How conservative is the glide path relative to the overall target date universe?"

Next, the plan can use the benchmark to perform attribution analysis to determine the source of a manager's returns. In normal market conditions (when risk is rewarded), one would expect a relatively conservative asset allocation to underperform the benchmark. Unlike single asset class performance comparisons, this does not necessarily imply that the manager is doing a poor job. If the management firm has allocated more of the portfolio to less-risky assets, then it is probably doing exactly what the sponsor wants it to do. On the other hand, if it underperforms because of poor fund selection, then perhaps it is not doing a good job. This is the kind of nuance that attribution analysis, which uses an appropriate, consensus-driven target date benchmark, can bring out.

If you would like to receive future issues, or if you would like to unsubscribe, please click {modify}Subscribe/Unsubscribe{/modify}