Target Date Funds in 401(k) Plans: Part II - Plan Participant Challenges and Proposed Solutions
As described in my last posting, Target Date Funds (TDFs) may appear to be an easy retirement plan solution, reducing plan sponsors’ administrative hassles and simplifying plan participants’ investment experiences by offering a diversified and rebalanced investment option. But assessing TDFs in greater detail, the alleged simplicity is revealed to be an illusion. It adds additional fiduciary responsibilities for the plan sponsor, as described in Part I. It also poses several distinct challenges for the plan participant.
TDF-Related Challenges for the Sponsor and Plan Participant alike
Since 401(k) plans are participant directed, participants are left to evaluate whether or not a TDF is right for them and, if so, which one.
The first challenge is understanding exactly what is meant by the word “Target.” Target is not a rate of return, nor a promise that a goal will be achieved. It means nothing more than what the asset allocation will look like on a future date, say, five years or 30 years from now.
Based on the lawsuits arising after the 2008 stock market crash, it is clear that participants interpret “target” as some sort of guarantee. They simply do not understand the complex nature and lack of guarantee implied in the name, “Target Date Fund.”
A sponsor who offers TDFs must be very careful to educate their plan participants about this misperception (and well document the education efforts they’ve made), so incorrect assumptions don’t cause inappropriate expectations. Participants need to be well aware of the risk inherent in the funds and what, exactly, they are designed to do. Offering investment options that participants mistakenly interpret as including a performance guarantee is a fiduciary disaster waiting to happen.
TDF-Related Challenges for the Plan Participant
Next, participants are left with the challenge of selecting one or more TDFs that will achieve their goals.
All I can say is good luck with that one. A TDF is mindlessly simple, in that it assumes that every investor in the TDF will need his or her money on a certain date (To Date) or starting on a certain date (Through date). If participants are unthinking and select a TDF based on their date of retirement or their age, they are assuming that the fund will meet their needs (as well as the needs of all investors in the fund), simply because they are a certain age or because they will retire on a certain date.
Yet if you asked the same participants if they felt that everyone their age had identical investment goals and needs, they would likely answer, “No.” And they would be correct. Investors cannot (or at least should not) make investment decisions only based on their age or retirement date. But these are the only factors considered by the traditional TDF.
Further, even if participants are considering their goals and how their investment option can best help them meet their goals, how can they possibly determine which TDF is the right fit? If the participant can determine that they need their account to grow at a certain rate of return, they are unlikely to have what they need to take the next logical step, and determine which TDF is most likely to provide that return. I say this because I do these calculations for a living, and I would be hard-pressed to figure it out.
And even if I do come up with an estimated future rate of return, my own plans can go right off the tracks if the TDF mindlessly reallocates at the wrong time. Say the market craters temporarily, as it does repeatedly, and the TDF rebalances out of stocks. When the market makes its inevitable rebound, the participants will own fewer equities on the way back up, which translates to lower expected future returns for them.
Model Portfolios: The Best Tools for the Job
In summary, TDFs are complex and, in my opinion, have no place in a 401(k). They are nothing more than a gimmick. What do I recommend instead? Keep it truly simple and offer professionally managed model portfolios.
Participants can easily be directed to a model that is right for them based on their unique financial situations rather than based solely on their age. By selecting a model, the participant has instructed the professional investment manager to implement a diversified portfolio comprised of multiple mutual funds or exchange traded funds. The participant has then hired that same manager to rebalance the account for them, and to monitor the underlying funds and make replacements as appropriate. The participant can adjust between model asset class portfolios representing the equivalent of their own personal “glide paths.” In this way they make and maintain their selections according to their unique goals and circumstances. To me, this seems like the wiser choice than TDFs.