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 firm’s with than 5,000 employees having TDFs in their 401ks. However, the market swoon of 2008 (and, into early 2009) brought a lot of attention to TDFs, and most of it was not 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 the mix of your investments 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, the managers of the fund make all asset allocation decisions for you.
TDFs, which are often mutual funds, hold a combination of stocks, bonds, and other investments. As time passes, the mix gradually changes according to the fund’s investment strategy. TDFs are funds are designed to match the long-term retirement dates that employees have in mind. The name of the fund often refers to its “target date,” such as “Portfolio 2040”, designed for employees who intend to retire near the year 2040. However, misunderstandings by employees can arise because TDFs, even if they have the same target date (e.g., 2040), can have profoundly different investment strategies and risks. Some employees assume that TDFs will guarantee that they will have enough retirement income at retirement, or that they can’t lose money, especially if they are close to the target date. In fact, TDFs do not remove the need for you decide before investing, and periodically thereafter, if the fund fits your situation.
Most TDFs automatically change the fund’s mix of investments in a way that becomes more conservative as you approach the target date. Over time, most TDFs shift from a mix heavily laden with stock investments in the beginning to a more bond weighted mix. This “shift” over time is called the fund’s “glide path.” Never the less, funds vary enormously in philosophy, underlying assumptions, glide paths, and what constitutes 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 really no consensus among TDF providers on appropriate glide paths. Furthermore, TDFs are typically designed for someone with an “average” risk tolerance, another concept that can vary dramatically by provider. In addition, TDFs with similar target dates also vary by when 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 employees they automatically enrolled in their retirement plans and who failed to elect their own investment options. This meant that some employees found themselves automatically invested in TDFs by their employer without any direct decision on their part. In the past, the default option for employees who did not elect their own investments was a money market or stable value fund. Because these funds historically did not keep pace with inflation, it was difficult for these employees to adequately fund their retirements. So the use of TDFs as the “default option” was seen as an improvement. Never the less, as discussed, TDFs have presented their own set of issues.
The problems with TDFs underscore the need for employees to evaluate the appropriateness of a target date fund before (and after) investing in one. At a minimum, employees 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
All this information is available in the fund’s prospectus.
Furthermore, when employees invest in TDFs they must incorporate all retirement assets they hold into the decision, including assets held outside their employer’s retirement plan (and even retirement assets held by their partner). In this era of personal responsibility and accountability, it’s imperative that employees educate themselves not only on TDFs, but on all the investments in their portfolio, especially those earmarked for retirement.
TDFs also don’t provide for a systematic method for retirees to make withdrawals from these funds. 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 such be part of a comprehensive retirement income plan.
Employees need to learn more about TDFs to assure they use them properly. No longer will the excuse “I didn’t know” suffice. Too much is at stake for employees to remain uninformed on these matters.