Target date funds have been around since the early 1990s, and they are gathering the vast majority of new money going into 401(k) funds.
But, few plan participants have a clue about what they are and how they work. This is a massive failure of plan sponsors, investment advisors, and Third Party Administrators to do their dut to provide basic information so that employees can make informed decisions to impact their basic retirement security.
Target date funds steadily reduce equity exposure under a fixed formula as the participant approaches the target retirement date. Because the participant has no direct control over the risk level he or she might prefer some other target risk allocation as an alternative funding solution.
Target date funds are the overwhelming investment of choice for Qualified Default Investment Alternatives (QDIA) in 401(k) plans. If the participant refuses to select any other investment plan, he/she is automatically placed in a target date fund determined by his age and years to retirement for the “average” participant. It’s hard to imagine that this single data point (age) can generate an ideal investment plan for any real world participant.
No two target date families are the same. Each fund family has a different philosophy for their target date series. For instance, Fidelity’s may be entirely different than Vanguard’s.
Glide Slope: The rate at which fixed income replaces equities to reduce risk as the participant approaches retirement may be vastly different. One series may be vastly more aggressive than its competition, and one may have a high degree of equity exposure at target retirement date while the other may have zero equities.
The glide slope design dictates the critical trade offs between safety and opportunity costs which in turn will dictate required funding levels to meet the target accumulation.
Asset Allocation: Within the equities one series may have high exposure to foreign and emerging markets while the other has zero or only token exposure. One may include real estate and the other not. Fixed income might be funded with TIPS in one plan while the other may utilize long term corporate bonds.
I’ll stipulate that the target date fund is probably a better choice for the QDIA than a money market fund. But, it’s unlikely to be the best choice for any particular participant. Coupled with the staggering amount of misunderstanding about purpose, construction and asset allocation decisions built into each target date fund the participant is unlikely to get the best possible outcome.
For starters, if the participant has defaulted into the fund as the plan’s QDIA the plan assumes that all participants want to retire at the same age. But, one participant may wish to work until age 75 while her peer may opt for early retirement at age 50. Clearly they both might require different investment strategies. But, because they are the same age, they will both have identical risk levels and investment strategies.
And even if they were to agree on how much they needed to accumulate, one has 25 years less to get there. So they probably will need to save and invest differently to achieve their goals.
If the participant makes a conscious choice for one of the target date funds provided in the plan, he/she can select an appropriate retirement date, but still has the problem of properly funding the account to meet his/her needs.
Once the participant lands in a target date fund, for good or for evil the program goes on autopilot. All investment decisions are made by the fund, and the equity exposure is steadily reduced. As a former military and airline pilot I liked autopilots. Once you pointed the airplane it continued along in that direction until told to do something else. That worked really well as long as you knew how the system worked and where to point the plane. But, the average plan participant may not know how the fund works or where his fund is pointed. Instead of an autopilot we have a misguided missile! Consider these alarming findings:1
- 48% believe that their target date fund guarantees that they will meet their retirement needs.
- 38% believe that their account balances can never go down.
- 38% believe that their account will be 100% cash at retirement
- 45% believe that their account is FDIC insured.
Of course, none of the above is true. You don’t have to be a financial genius to imagine all the mischief this might cause. Given this massive level of misunderstanding how can we ever expect participants to make rational choices to secure their retirement?
It’s not enough to have even the world’s best target date fund as your company’s QDIA. The target date Fund is not a silver bullet that will magically solve all the participants retirement needs by itself. They are just another potentially useful tool in the plan’s alternatives. Unless properly matched to the employee’s situation and properly funded, even the best is not a stand alone solution.
Employee education on all aspects of retirement planning is critical if your participants are to have a decent shot at a secure retirement. Plan sponsors have a responsibility to insure that there is a clearly defined structure to provide it to all their employees.
1Alliance Bernstein. “Inside the Minds of Plan Participants: Who’s Ready, Who’s Willing, Who’s Able…Who’s Not.” Alliance Bernstein. 2015. https://www.alliancebernstein.com/defined-contribution/us/resources/pdf/DCI-6115-1115.pdf.