Introduction Seed it and fughettaboudit! That’s the claim made for the use of target-date funds in 401(k) plans -- the hot new choice for 401(k) line-ups.
In the U.S., the average 401(k) plan participation rate is less than 72%. In addition, 55% of 401(k) plan participants have never rebalanced their account and 26% actually choose their 401(k) investment options by guessing or dividing equally among the fund options. This is a critical situation, and it points to a dire need for an alternate, simpler choice. A plan sponsor can simplify the enrollment process by having investment choices that only require one to check a box. One of several ways to accomplish this is to use target-date funds as an exclusive fund option in a 401(k) plan line-up.
Target-date funds are built to take care of asset allocation and rebalancing decisions for those who just want to take their hands off the wheel. They are normally built as self-contained portfolios of several different mutual funds. Each fund is a mix of cash, bonds and stock funds, including in many cases some foreign stock funds. As the years go by, a participant's account is routinely rebalanced and becomes incrementally more conservative. The theory is that as one's retirement date arrives, the changing asset mix will provide the proper recipe for stability and growth.
This sounds like a great idea in theory, but as in all other investment choices you must look at both the pros and cons to make a prudent decision. Some of the pros include simplicity for sponsors and participants, and the ability to "set it and forget it." Among the cons is the problem of poor education programs and misuse of the fund. Many people who have money in a target-date fund have it in there incorrectly.
There are a growing number of target-date funds offering investors a fund that matches their expected retirement date. At the end of last year, about 55 companies offered these products, according to Lipper Inc. The biggest players are Fidelity Investments, with a 33 percent market share, and the Vanguard Group, with about 17 percent. Even AARP now has a set of funds.
Fire: How to Choose The formula seems simple. Determine the year in which you want to retire and put a bull’s eye on the calendar. Go to your 401(k) or IRA and find the target-date mutual fund that matches your retirement date. Start putting your retirement dollars into that one fund.
For the plan committee, it is important to make sure that a full complement of funds are available to meet the needs of your participant demographics. If you have employees whose age ranges from 25 to 65, then you need a set of funds that span from 2010 to 2050. That’s the easy part. The key to choosing success is in the “Aim”-ing.
Ready: Gathering the Data One of the difficulties with these funds has been figuring out how well they should be performing. It is important to determine what to compare them to because no two target-date funds are alike.
Dow Jones recently launched a new series of indexes to help investors gauge the performance of these all-in-one products. Plan committees can access indexes at
www.djindexes.com/mdsidx/portfolio/
index.cfm?eventshow
PortfolioTargetDateHome.
The concept of a target-date plan is a good idea, but in practicality they can be very difficult to implement, monitor, and understand.
Understand Risk The asset allocation of a particular fund may not suit the risk tolerance of all individuals who plan to retire in a given year. The Plan Committee should be sure to understand the risk levels associated with each fund chosen. Each fund family that offers target date funds has a different idea of risk levels, so it is best for the committee to define those levels before making the choice.
Understand Asset Allocation within the Fund The asset allocation for a specific target-date fund can vary from one firm to another. Not only that, but it will change by design each year. Choose funds that meet your participant demographics: age dispersion, investment knowledge, and the likely participation in the education process. When in doubt, it may be better to err on the conservative side.
Cost Most target-date funds are funds of funds, so cost is very important. Costs range from no management or administrative fees to up to 1 percent in addition to the cost of underlying funds. Make sure your analysis includes the cost of both the target-date fund itself as well as the cost of the underlying funds. Avoid front-end sales charges, deferred sales charges or any redemption fees.
Aim: Consider the Fund Family Theoretically, participants are choosing a fund for their working life. This is a heavy burden for the Plan Committee because participants will be putting all their eggs in one basket. Target-date funds are only as good as the fund family providing them. And because you’re committing to the fund’s overall investment strategy over the very long term, you must be certain you have high-quality investment managers.
One way to measure the quality of a fund family can be found at Fiduciary Analytics (
www.fi360.com), which provides a quarterly review of 270 fund families.
Hitting the Target First of all, you may have guessed that Ready, Aim, Fire will work much better than the typical scenario. Secondly, target-date funds are a service, not just an investment. Up-front evaluation of the fund family, fund risk, and participant needs are among the most important steps to a successful choice.
The decision to add a series of target-date funds should be weighed carefully by the plan committee. In reality, these funds are not right for every situation. They are fairly complicated financial instruments and need to be understood by the committee before they are offered to the plan participants.
This article was reprinted with the author's permission. It has been amended slightly since original publication. A longer article on target-date funds by Al Otto will be included in an upcoming issue of the PSCA magazine Defined Contribution Insights.
Al Otto is Vice President of White Horse Advisors, a comprehensive financial consulting and planning firm. For more information about White Horse, visit
www.whitehorseadvisors.com. Mr.Otto can be reached at (678) 322-3000 or via email at
al.otto@whitehorseadvisors.com.