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In Practice

Why Picking the Right Benchmark for Target-Date Funds Matters

What questions to ask when selecting an appropriate benchmark

America’s retirement readiness depends heavily on the ability of target-date funds to deliver good outcomes. More than 90% of U.S. defined-contribution plans offer target-date funds, which are by far the most common default option. Additionally, target-date funds also claim the bulk of new contributions.

Yet, assessing whether these funds are on track to deliver outcomes that meet the goals of retirees remains a challenging, vexing problem. In my opinion, here’s the root of the problem: Target-date funds developed faster than the benchmarks that track their performance—and with good reason. These funds are inherently difficult to benchmark because of their unique and complex nature. Target-date fund families offer multiple funds, all of which are designed to evolve over time.

The result is that more than half of the target-date funds in Morningstar, Inc.’s open-end universe name a non-target-date index, such as the S&P 500, as the primary benchmark. I believe this is egregious.

Quality target-date indexes are offered by a variety of providers, including S&P Dow Jones Indexes and Morningstar® Indexes. We urge target-date fund boards, shareholders, and plan fiduciaries to demand an appropriate benchmark for target-date funds.

Selecting and using a target-date index can be complex, but a consultant or index provider should be able to help.

The challenge of choosing a benchmark for target-date funds

Selecting an appropriate benchmark family for a target-date fund family is far more challenging than the traditional benchmarking problem. In addition to the standard characteristics of good benchmarks recommended by the CFA Institute, we recommend asking three additional questions:

  1. Is the glide path of the benchmark similar to the glide path of the target-date fund?
  2. Are the asset classes similar?
  3. Do the benchmark and fund use similar asset class weighting schemes?

In our recently updated paper, “ Selecting a Target Date Benchmark,” we offer a framework for picking an appropriate target-date family of benchmarks, including three measures for quantifying fit.

A framework for using a benchmark for target-date funds

Benchmarking traditional single-asset class funds, such as a U.S. small-cap fund, is relatively straightforward. The task is easy because a typical single-asset class index is nearly void of subjectivity—its constituents typically follow an objective market-capitalization weighting scheme. While the rules and cutoff points may vary a bit between index providers, the indexes are almost nearly perfectly correlated with one another. For instance, all U.S. large-cap indexes are tightly correlated, all U.S. small-cap indexes are tightly correlated, and so on.

But this is not true in the target-date space, where the performance, correlation, and index composition can vary widely. Target-date indexes are in fact strategies that are formalized as indexes. We strongly advocate benchmarking target-date funds relative to an appropriate target-date index. But because this is essentially comparing the performance of two strategies, it’s a much more complicated process.

In our paper, “ Using a Target-Date Benchmark,” we provide a detailed framework for decomposing performance into three factors: glide path, detailed asset allocation, and manager selection.

Please see below for important disclosure.

Learn more by downloading our full paper, “Selecting A Target Date Benchmark.”
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