Many 401k plans now include target date funds, which afford participants a much-needed opportunity to “set it and forget it”. In concept, this is a great idea. Study after study shows that allocating your assets and letting them ride for the long haul (with periodic adjustments or rebalancing) is the best way to prepare for retirement. However, while the core idea of TDF's is good, the typical execution is not.
The best thing about TDF's is that they bring the element of professional investment management back into a plan. This provides the participant with at least an option to have a professional manage his investment with a stated retirement date in mind. TDF's have proven to be far superior to a participant building a portfolio from his plan's fund options (with or without the aid of an advisor!). Unfortunately, there are several pitfalls that plague the average TDF and they are so significant that, as they are employed today, they may do more harm than good.
1. They do not measure the participant’s risk tolerance. When a 401k plan participant selects a target date fund, she’s selecting a fund that reflects how many years she has until retirement, which is great. However, the allocations in that fund may or may not match her tolerance for risk. For example, a TDF with a far-off retirement date will be quite aggressive in the early years. If this particular participant is more conservative, it’s likely that she will panic if there’s a dip in the market. If she then moves her money to a more conservative choice, she's made a mistake from which she can never recover.
2. The underlying funds in a TDF are often "dogs". Every fund family has some poor performers among their funds—2 or 3 star funds that would never be selected on their own merit. TDF's are a common destination for such funds, because their individual performance is masked. You can prove this for yourself by looking at each component fund and checking them out on Morningstar.
3. Cost. TDF's, like the plans they live in, are heavily comprised of actively-managed funds. There is no performance justification for the higher cost of actively-managed funds—let alone the typically higher cost for TDF's made up of such funds.
4. Added confusion/negatively- affected participation. TDFs are usually offered alongside other investments and thus positioned as just another investment. So instead of simplifying the task for the participant, it becomes more complicated. Employees consistently say they are confused by lots of investment choices. In fact, studies show that they are actually repelled by investment choices and accompanying jargon. Offering a TDF as another investment retards participation.
The idea behind TDF's is great—professional management, set it and forget it. But to be effective, a TDF needs to be the only type of investment in a plan and it should be comprised of low-cost index funds , which outperform their active counterparts more than 80% of the time. Participants should choose their TDF based on both time horizon and their personal risk tolerance. These little rules will result in:
- Much lower cost
- Much less confusion and thus much improved participation
- Better and more consistent returns on plan investments
- Participants invested in a way that makes sense for them and reflects their risk tolerance, so
- Improved participant investment behavior at every key decision point along the way.
Are any or all of these included in your definition of a successful plan?
Want to learn how your investment lineup affects participation in your 401k plan? Check out our free Participation Guide!