Tuesday, October 12, 2021
The use of Target Date Funds (TDFs) has risen tremendously within 401(k) and 403(b) plans, although there is still a lot of confusion on how these actually work. To provide some perspective on these funds, let’s look at their intended use, the differences in their construction, and the misconceptions many have about them.
What is a Target Date Fund?
TDFs are the age-based, asset-allocation portfolios in your plan, the ones with a year in the name of the fund. They are often a “fund of funds,” or a collection of mutual funds packaged into one portfolio. They were designed as an option for someone who didn’t want to pick their own “pie chart,” or the mix of funds they would invest in. With TDFs, the investor doesn’t need to know anything about investing; they just need to know when they are expecting, or “targeting” to retire. In that way, they can “set it and forget” like the infomercial used to say.
What’s unique about TDFs is that they adjust their risk level every five years or so, allowing the fund to age with the investor. It invests very aggressively when the individual is younger, or further from retirement, and tapers the risk level as they age so that it is more conservative near their retirement date. This, however, leads to the “to or through” argument:
“To” TDFs: Some fund managers believe in managing an investor’s risk “to” their retirement, meaning that the portfolio reaches its most conservative point at their retirement date, and stays consistent for the remainder of the time invested. A major assumption in this thinking is that the employee will withdraw their funds at retirement and roll them over to another investment option (e.g. an IRA).
“Through” TDFs: The other camp of investment managers believes in managing risk for an investor through their life expectancy, with the most conservative point being 15-30 years beyond the employee’s retirement date. The major assumption here is that the investor will stay invested in the portfolio, even after retirement.
This philosophical difference creates a large variance in how these portfolios are managed as employees near retirement, specifically in the ten years before and the five years after retirement age. A “to” fund will have 20%-40% invested in the stock market during that window, while a “through” fund will invest between 50%-70% in that same time period. However, because the fund has the same year in the name, they are improperly compared to each other because they will perform very differently based on how the stock market is performing.
Key Differences of TDFs
In addition to their age-adjusted risk, other differences in how TDFs are built include:
– Some stick to traditional asset classes like stocks and bonds while others also include alternative assets
– Some TDFs are made up of actively managed funds versus others that are built with passively-managed index funds (some also feature a blend of both)
– Some are composed of funds from a single fund manager while others are made up of funds from multiple fund managers
– Some allow for a portion of the portfolio to use a “tactical” approach that can adjust based upon the ebbs and flows of the markets
All of these factors make evaluating a TDF a unique process, and one that plan fiduciaries must pay particular attention to as they look out for the best interests of participants.
Common TDF Misconceptions
Even though so many employees choose these funds and they have become the dominant default option for plans, there are some common misconceptions, or misuses, of TDFs among employees and employers alike:
– Using more than one TDF to build your portfolio. When an investor selects more than one TDF, they defeat the purpose of the intended mix of funds that they hold. They are investing in the same underlying funds across portfolios, just at different percentages. The same holds true for picking a TDF among a list of other funds.
– Picking the TDF offered by your plan’s recordkeeper. Many recordkeepers will provide you with a discount if you use their house funds. You will want to make sure that they can stand on their own merits before offering them to your employees.
– Being locked into a particular TDF until the date in the name of the fund. The name is only a guideline as to how the manager is managing the risk within the fund. There is no requirement that an investor stay in the fund for any period of time.
– Picking the TDF that lines up with the year an employee turns 65. It’s called a Target Date Fund, not a Target Age Fund. Investors pick the date they plan to retire and select the corresponding fund. Many will choose their age 65 year as a best guess, and many plans default to that year as well. However, it’s not a requirement to use that year.
– Believing the TDF guarantees the money will be there on the retirement date. There are no guarantees in these funds, period. They can gain or lose money just like any other fund.
– Thinking the TDF is a consolation prize. These portfolios were specifically designed for investors who don’t fully understand investing or want someone else to handle it for them, which make them an appropriate option for a large portion of the population. Most people are better off in this type of portfolio (or some other managed option) than blindly picking funds on their own.
TDFs take on many shapes and sizes, and it’s important to do your due diligence. While the funds are intended to allow your employees to put their retirement investing on auto-pilot, the selection and monitoring process for them is anything but set it and forget it.
Jim Sampson is the Director of Retirement Advisory Services at Hilb Group Retirement Services in Warwick, supporting retirement plans for companies and their employees for the last 24 years, and is the co-author of the book Save Like a Champion Today, A Winning Game Plan for Retirement.
Investment Advisory services offered through Global Retirement Services (GRP), DBA Hilb Group Retirement Services, a registered investment advisor.