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Tuesday, September 16, 2014

Why Most Target Date Funds Are Off-Target

As a basic premise, every 401k plan should enable every participant to maximize retirement savings on his Custom_TDFsor her timetable.  To accomplish this, plan costs should always be kept as low as possible and each participant needs be able to invest in a way that reflects his personal risk tolerance, thereby growing his account at a level of risk that is comfortable for him.  Consistent returns are clearly important as well.

Every plan needs to either provide education that enables the participant to create an appropriate, personal portfolio and then manage that portfolio on an ongoing basis or, provide some "managed" option that does this for the participant.  Given the well-documented failure of investment education and the resultant, miserable participant decision-making and results, the target date fund (TDF) concept has emerged as a solution.  Many plans offer them and they are attracting more assets than ever.

The intention of “off-the shelf” Target Date Funds is good.  They’re professionally constructed and managed, they eliminate much of the need for investment education and the fruitless effort to turn plan participants into competent investors, and they encourage a set-it-and-forget-it mindset.  But they also come with a bag of problems. To name a few:

  1. High cost - either because of actively-managed funds, management fees or both

  2. Nearly always comprised of relatively poor-performing funds

  3. Don't take into account the individual's risk tolerance

  4. Don't get re-balanced frequently enough (usually only yearly)

  5. As a result of #3, it's more likely that participants with a low to moderate risk tolerance will "run" when the market goes down. (TDFs are too aggressive in the early years for these people)

Properly constructed, there should be no cons to a target date fund.  However, customization is key.  A great TDF: 

  1. Can be low cost - via low management fees and use of all index funds

  2. Can provide persistently better returns - index funds outperform actively-managed funds 80+% of the time

  3. Reflects both the individual's risk tolerance and the various time horizons

  4. Is professionally managed

  5. Is re-balanced quarterly

  6. Encourages a set-it-and-forget-it mindset

The most critical aspect of the "target date" concept is that, when offered in a front-and-center manner, (i.e., not as just another investment choice among many), employees are not repelled by the complex, incomprehensible and off-putting jargon of investments, so they join the plan. Not saving (non-participation) is the single biggest problem for employees, and non-participation is the biggest reason that plans fail their non-discrimination tests.  Using target date funds properly can solve these and other problems to make every 401k plan successful for employee and employer alike.

The bottom line is this:  the success of TDFs in your plan (meaning they achieve the basic plan premises cited above) depends entirely on who builds the custom funds and how they are deployed in the plan.



Posted by at 10:00 AM