Over the past decade, Target Date Funds (TDFs) have become the “go-to” investment for 401k retirement plans. Currently, there are over $500 billion in assets in TDFs, and more than 40% of 401(k) plan participants are invested in them. Often, they are sold as a “one-size-fits-all” solution, but are they right for you and your participants?
It’s easy to see the attraction to TDFs. Most participants left to their own devices are usually unskilled at creating their own investment portfolios. TDFs provide a simple solution to give them access to a diversified portfolio of funds. But since the market meltdown of 2008, they have received increased scrutiny from the Department of Labor (DOL), and plan sponsors alike.
In 2008, the most conservative TDF options lost between 3.5% and 41% of their value. How could a fund designed for someone retiring in a couple of years possibly lose 41%? That was the question everyone was asking. The answer was simple: A 2010 fund (the most conservative option in 2008) from one mutual company was very different from a 2010 fund from another mutual fund company. Equity allocations in these funds ranged from 20% to over 50%. There is no standardization when it comes to equity and fixed income allocations in these TDFs.
Target Date Funds generally fall into two categories—those that manage their asset allocation strategies in a “To Retirement” manner, and those that manage “Through Retirement.” Depending upon which strategy your TDF manager uses, the equity allocation at retirement can vary widely. In addition, each TDF manager has his own glide path. The glide path is how the fund manager changes the mix of stocks and bonds as the fund gets closer to retirement age. This can have a dramatic effect on the amount of risk a TDF takes on as your employees get older and closer to retirement.
One other drawback of target date funds is that most of them do not take risk into consideration. They assume that two people who are the same age should invest in the same portfolio. In our experience, risk tolerance is very diverse even among participants of the same age.
So, given the popularity of TDFs in 401(k) plans, and acknowledging that they will continue to attract millions of dollars in new assets, what is the best course of action for you as a plan fiduciary?
First, consider whether TDFs are right for you and your employees. There are other options available, and having customized, risk-based portfolios built for each individual may be the best choice.
If you decide that you want to invest in TDFs, you have to figure out which suite of TDFs is right for you and your employee base. Some questions to answer beforehand include:
- What is the investment sophistication level of your employees?
- Is your plan generous with matching and profit sharing contributions?
- What is the average age and salary of your employees?
- Does your Investment Policy Statement include criteria for selection and monitoring of TDFs?
- Did you merely accept the TDFs that your record keeper offered you?
- Answering these questions will help you better evaluate which target date funds are appropriate. If you do not perform a due diligence process of evaluating the different TDF suites available, some serious consequences can arise.
While Target Date Funds are often marketed as one-size-fits-all or as a set-it-and-forget-it solution for participants, they also require more oversight from you as a plan fiduciary. In the end, a custom model designed around your specific needs and managed by a 3(38) fiduciary can yield better results with less liability.