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Target Date Funds in 401(k) Plans: Part I - Plan Sponsor Challenges

Target Date Funds (TDFs) have become a popular investment option in 401(k) plans. A TDF is a mutual fund made up of many different “underlying” mutual funds with an effort made to diversify across many asset classes (U.S. and foreign stocks, bonds, cash, etc.). In this regard they are a fund of funds, but they come with a twist. The asset allocation will automatically become more conservative over time by periodically reducing the allocation from more volatile assets classes such as stocks into less volatile asset classes such as bonds and cash.

The objective of a TDF is to give the investor/participant a way to achieve both diversification and automatic rebalancing into an ever more conservative portfolio as the investor ages. On the face of it, offering a number of TDFs, each with a different “target date” sounds like a pretty smart investment option for plan sponsors (employers) to include in their 401(k) plans. But like most plan sponsor responsibilities, it is not that simple.

TDFs come with challenges for both the plan sponsor and participants alike. As a result, it is my opinion that professionally managed model portfolios are a much more sensible investment option for your 401(k) plan. In my two-part series on TDFs, I will first cover issues of concern to you, the plan sponsor and next address areas of concern to the plan participant. Let’s start with the plan sponsor.

TDF-Related Challenges for Plan Sponsors

I’ve often seen TDFs marketed as “easy” solutions for the plan sponsor since they come in the guise of a turnkey plan solution. But when I peek into the details, I’m not seeing the simplicity.

Just a quick reminder that plan sponsors (employers), as well as anyone else who manages (i.e., exercise discretion or control over) your plan’s assets are fiduciaries to your plan. One of many fiduciary responsibilities is to have a written policy for selecting and maintaining your plan’s investment options. Failure to comply with this requirement can lead to a fiduciary breech and result in personal liability. Of course any acceptable policy will require that you understand each investment option and document why the particular investment option is sound.

In our experience, the vast majority of small plan sponsors fail this test in that they are unfamiliar with the details of the target date funds they offer their participants. Some questions that need to be answered and knowledgably defended are:

  • What is the risk-return profile of the fund today? I.e. how much stock in relation to bonds and cash? More specifically, do you understand the asset allocation in the fund and have you evaluated it for appropriateness? As of this writing, the American Funds Target Date Retirement 2030 fund has 80% stock, while the John Hancock Retirement 2030 fund has 68%. Which is right for your plan participants?
  • What is the “glide path” for the TDF? I.e. how quickly or slowly will the fund reallocate from its present level of return and risk to a more conservative level? Is the glide path acceptable? Why is it acceptable?
  • Is the fund’s target a “To” date or a “Through” date? “To” date funds are designed for investors who will need and withdraw the funds on the “To” date. “Through” date funds are designed to stay invested through the target date. Corollary question: Why did you choose a To or a Through?

Another reminder is that ERISA and the Department of Labor (DOL) require plan sponsors either to be investment experts or to hire one. Relying on the broker who sold you the plan platform and recommended the investment options is not being an expert nor is it having hired one. If you offer TDFs in your plan and the questions above have not been answered, you have breached your duty to the plan participants by failing to implement a prudent written investment option selection and monitoring process.

If you’re scratching your head around now, you’re not alone. A recent survey by Dimensional Fund Advisors (as reported in Pensions & Investments, “Few ‘Very Satisfied’ With Target Date Funds,” August 1, 2011) found that nearly half, 45 percent, of Defined Contribution plan executives had concern about understanding TDF glide paths, and another 41 percent had minor concern.

This is not a surprising discovery. After all, most small plan sponsors’ primary role is to run their business, not act as financial pros. In my next posting, I’ll continue to explore the additional complications related to participants’ use of TDFs. I’ll wrap with how I recommend you build your plan’s selections according to the basics of sound investing – for your own and your participants’ best interests. Of course you can be in touch with me sooner if you’d like to know more right away.

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