Target-date funds, also known as lifecycle funds, are rapidly rising in 401(k) plans as the favorite qualified default investment alternative because they're much more appropriate than the traditional money market fund for hands-off investors.

In theory, you simply pick the target date that's closest to when you expect to retire, and you're done. The fund rebalances your asset allocation over time, growing more conservative as you grow older. If only it were that simple.

With 248 different lifecycle funds to choose from at the end of 2007, according to the Investment Company Institute, plan sponsors can have a tough time selecting the plan most appropriate for their needs. Even target-date funds with the same target date, such as the year 2020, can range from being quite aggressive to conservative, depending on their glide path.

"The percentage of equity at the time of retirement can vary between 20% and 60%," says David Musto, managing director of retirement and defined contribution investment-only business for JPMorgan Asset Management. "These are fairly significant differences. Until now, there hasn't been a simple construct for differentiating between plans."

According to the ICI, approximately 88% of lifecycle fund assets are held in retirement accounts. Assets in lifecycle and lifestyle funds totaled approximately $421 billion at the end of 2007, up from $303 billion the previous year. Lifecycle fund assets were $183 billion in 2007, up from $114 billion in 2006, or an increase of 61%.

Late last year, JPMorgan unveiled its target date navigator tool, which helps plan sponsors and advisers sort through all the choices. According to the company, the navigator is the first framework that categorizes funds according to their glide path strategy and investment composition.

When JPMorgan started looking into the target-date world, it found a disconnect in the alignment of participants' behaviors and needs, plan sponsors' goals and target-date strategy selection. The firm realized that more could be done to help advisers and plan sponsors distinguish between competing funds, while at the same time addressing fiduciary responsibilities in selecting and monitoring those investments.

The company says it's "tool fills a necessary void in the marketplace in determining which funds might best fit the particular needs and the goals of each retirement plan."

Advisers, plan sponsors and their clients are recognizing the impact of selecting the right target-date approach, Musto says.

When he looked at the approximately 40 different target-date strategies in the mutual fund arena, he found they could be categorized into four groups. The navigator's goal is to parse out that universe and categorize the different products into like areas.

"The target date navigator doesn't seek to demonstrate that any one strategy is good or bad, but rather which strategy is the right fit," according to Musto.

Thus, the navigator splits the target-date universe into four quadrants, like the points on a compass.

The northwest sector has funds with higher levels of diversification and less equity at the time of retirement, the northeast sector has higher levels of diversification and higher levels of equity, the southwest sector has lower levels of diversification and lower equity, and the southeast sector has lower levels of diversification and higher equity.

"It's good at helping to describe the different trade-offs," Musto says. "In the hands of independent advisers, this could become the industry standard for target-date fund categorization."

Other scoring systems

Aliso Viejo, Calif.-based 401(k) Advisors came up with a similar system a year ago for scoring funds and their managers, which it dubbed the retirement plan advisory system. That system's scorecard involves creating customized benchmarks based on underlying asset allocations.

"All complex problems have easy-to-understand wrong solutions," says 401(k) Advisors President Nick Della Vedova. The trick is understanding what benchmark to use for which peer group, he says.

The scorecard is broken up into four areas in order to reduce exposure to fiduciary liability for plan sponsors, says Jeff Elvander, chief investment officer for 401(k) Advisors.

Thirty percent of the scorecard looks at style factors, 30% at risk return, 20% looks at peer groups, and the remaining 20% considers qualitative factors, he says.

The scorecard considers things like manager tenure, fund expenses and the strength of its statistics. For example, the scorecard asks if the manager who was responsible for the last five years of performance is still with the fund.

"It makes sense of institutional material and provides a roadmap for identifying managers," Elvander says. "Is the manager's recent success attributed to luck or to skill?"

Many managers can outperform a benchmark during a given quarter, but they may have just gotten lucky. Luck is the flip of a coin, he says.

Many skilled managers consistently outperform their benchmarks. The scorecard uses analytics, style analysis and risk measures to identify who has demonstrated that skill, according to Elvander.

"We do not score funds on absolute performance," he says. The scorecard looks at the median rank, eliminating the high and low quarters. "In the 401(k) world, it's about procedural prudence."

The scorecard allows participants to make very sound investment decisions, according to Della Vedova. It also allows them to evaluate and build their own package so they can have more control over money managers.

Della Vedova says many plan sponsors are seeking customized allocation models that are based on the funds they choose, rather than prepackaged models.

"There is no one benchmark that applies to every fund," Elvander says. "That's why you need custom benchmarks. There is no one single style. They're all different."

Morgan is a writer for Money Management Executive, an EBA sister publication. He can be reached at john.morgan@sourcemedia.com.

Time to review

Plan sponsors are taking their fiduciary responsibilities seriously and dealing proactively with the financial crisis, suggests a new survey from Aon Consulting.

Of the 100 defined contribution plan sponsors recently surveyed, 78% have reviewed their plan's core offerings to ensure they have sufficient diversification. Of the 81 defined benefit plan sponsors that responded, 62% have reviewed the current economic turmoil's impact on their pension costs, and another 33% intend to do so.

"Sponsors aren't ignoring the situation," says Barry Gros, a vice president in the retirement practice at Aon in Toronto, adding that the push for governance in recent years appears to have had a positive effect. "From a governance perspective or a management perspective, things are better off than I actually thought they might be."

On the DC side, 49% of plans have evaluated the risk exposure associated with managers that maintained a high level of exposure to securities of financial firms that have experienced significant upheaval, such as Lehman and AIG. The other 51% have relied on recommendations from their vendors.