At their core, TDFs are professionally managed asset allocation policies. Questions therefore naturally arise around how (or even whether) they should be benchmarked with market indices. The investor(s) on whose behalf a particular policy is undertaken may have highly subjective criteria for success that have very little to do with outperforming market benchmarks. For example, if I have a specific goal toward which I earmark some assets, in any given year I probably care more about making progress toward my goal than I do about outperforming the stock market.
However, we should not be led astray by false choices. We do not have to choose between market-based or goals-based benchmarks – we need to intelligently use both. If my large-cap fund manager consistently underperforms the S&P 500, there may be a very good reason for it. Maybe she is taking a lot less risk. Or maybe not. In either case, I ought to know about it, and having the S&P 500 as a proxy helps me to understand the opportunity, and risks, available in large-cap stocks. The market benchmark helps me make an informed decision about who should manage my hard-earned capital, as well as the overall portion of my resources that I should devote to the large-cap category.
Many stakeholders get hung up on how to benchmark TDFs because they include multiple asset classes and provide more holistic investment programs than single-asset class funds. Investors should be aware that benchmarking with market-based proxies enables better informed choices. For example, some TDF managers generally underperform market-based benchmarks because their policy is to invest more in fixed income than competitors. There is nothing wrong with that and many investors seek such exposure. To understand why managers perform in certain ways, referencing market-based benchmarks of the TDF universe provides valuable information. Benchmarking custom TD strategies is no different. Whether a plan selects a custom solution to create a more diverse asset allocation, have more control over underlying managers, or build a glide path that addresses unique plan demographics, the only way to fully gauge the impact of the decision to go custom is to compare results, and asset allocation, with a market-based proxy. In some instances, it may be eye opening for retirement plan sponsors to see that their custom glide path is not very different from the market consensus. In others, comparing the custom glide path with the market consensus may validate the decision to go custom. Either way, it’s better to be mindful of overall opportunities and risks within the TDF category, and to be conscious about deviating from the consensus where appropriate, via reference to a market benchmark.
If you are interested in a comparison of TDF performance with a market-based consensus glide path, as represented by the S&P Target Date Index family, please see our latest Target Date Scorecard.The posts on this blog are opinions, not advice. Please read our Disclaimers.