The growing presence of Target Date Funds (TDFs) in Defined Contribution Retirement Plans has been meteoric. In 2004, only 13% of Retirement plans had such funds. That percentage grew to well over 90% in 2020, with virtually all firms with over 5,000 employees having TDFs in their 401ks. However, the market swoon of 2008 (and early 2009) brought a lot of attention to TDFs, and most of it wasn’t good. Employees expecting to retire in 2010 (and thereby choosing a “2010 TDF”) testified to a joint hearing of the U.S. Department of Labor and the Securities and Exchange Commission that they “were shocked” by the steep losses in their “2010 TDF.” In fact, the average “2010 fund” lost 23% of its value in 2008, with at least one 2010 fund down 60%. Many (including government regulators) were asking how this could have happened.
TDFs are designed to make investing for retirement convenient by automatically changing your investment mix over time. Most investment professionals agree that “asset allocation,” which involves dividing your investments among the various asset classes, such as stocks, bonds, and cash, as the single most important investment decision an investor will ever make. Once you select a TDF, managers of the fund make all asset allocation decisions for you.
TDFs, which usually consist of mutual funds, hold a combination of stocks, bonds, and other investments. As time passes, the mix gradually changes to match the long-term retirement dates of employees. The TDF’s name refers to its “target date,” such as “Portfolio 2040”, set for employees who intend to retire in 2040. However, employee misunderstandings can arise because TDFs, even with the same target date (e.g., 2040), can have markedly different investment strategies and risks. Some employees assume that TDFs will guarantee them enough retirement income or that they can’t lose money. In fact, TDFs do not remove the need for the employee to decide if the TDF fits his/her situation.
Most TDFs automatically change the fund’s mix of investments to becomes more conservative as the employee approaches the target date. Over time, most TDFs shift from a mix heavily laden with stock investments to a more bond weighted mix. This “shift” is called the TDF’s “glide path.” Nevertheless, funds vary enormously in philosophy, underlying assumptions, glide paths, and what is an appropriate portfolio for a given age. For example, the percentage in equities in 2010 Funds vary from less than 15% to over 60%. This happens because there is no consensus among TDF providers on appropriate glide paths. Furthermore, TDFs are designed for someone with an “average” risk tolerance, which varies significantly by provider. In addition, TDFs with similar target dates also vary by the date they arrive at a stable income glide path. Some achieve this at the “target date,” while others not until 20 or even 30 years beyond that date.
Problems grew with TDFs because a provision in the Pension Protection Act of 2007 allowed employers to use TDFs as “the qualified default investment option” for 401k enrollees who failed to elect their own investment choices. Therefore, employees found themselves automatically invested in TDFs by their employer without a direct decision on their part. In the past, the default option was a money market or stable value fund where the principal was guaranteed. Because these funds historically did not grow enough to keep pace with inflation, these employees fell short in funding their retirements. So, TDFs as the “default option” was seen as an improvement. Nevertheless, as we’ve seen, TDFs have their own sets of problems.
At a minimum, employees must evaluate the appropriateness of a TDF before (and after) investing in one. They must consider a TDF’s:
-asset allocation over its entire life
-its most conservative investment risk
-its risk level and glide path
-its performance, and its fee structure
This information is available in the TDF’s prospectus.
Furthermore, when employees select a TDF they should consider all their assets earmarked for retirement, including assets held outside their employer’s retirement plan, assets held by their partner, and guaranteed incomes they (or their partner) may have.
Also, TDFs don’t provide for a systematic method for retirees to make withdrawals to fund their retirement income needs. Unless instructed otherwise, withdrawals will consist of taken from each asset class equally within the fund. This may or may not serve the best interests of the retiree. These withdrawals must be part of a comprehensive retirement income plan.
Everyone must learn more about TDFs to use them properly. No longer will the excuse “I didn’t know” suffice. Too much is at stake for people to remain uninformed.