Nearly a decade ago, Congress passed the Pension Protection Act of 2006, a multi-faceted piece of legislation that aimed to protect the retirement assets of the nation’s workers. While the primary goal of the Act was to deter companies from habitually underfunding their traditional defined-benefit pension plans, some of the secondary elements of the law have arguably had a greater long-term impact on the financial industry.
Among other provisions, the Act created a “safe harbor” status for 401(k) plan sponsors, extending liability protection for fiduciaries who establish default multi-asset class investment vehicles for participant contributions. When the Department of Labor (DOL) further defined the requirements of these default investments (known as Qualified Default Investment Alternatives, or QDIAs), stable-value and money market funds were excluded from the definition of QDIAs, except in very limited circumstances. Because the vast majority of 401(k) plans had been using these sorts of funds as their default investment options (and some still do), the new law forced plan sponsors to look elsewhere in order to satisfy their legal duty to their participants.
According to the DOL guidelines, QDIAs generally have to fall into one of three basic categories:
- A product with a mix of investments that takes into account the individual’s age or retirement date (target-date fund)
- An investment service that allocates contributions among existing plan options to provide an asset mix that takes into account the individual’s age or retirement date (professionally-managed accounts)
- A product with a mix of investments that takes into account the characteristics of the group of employees as a whole, rather than each individual (balanced fund)
Overwhelmingly, the response among plan sponsors was to embrace target-date funds, as the following chart confirms.
While target-date funds had existed in the market since the mid-1990s, the DOL guidelines sparked explosive growth in the vehicles. According to research from Morningstar, total assets invested in these funds (primarily managed by Fidelity, T. Rowe Price, and Vanguard, who boast a combined 75% market share) have grown from less than $100 billion to well in excess of $600 billion in just ten years.
Given their increasing prominence in the world of retirement investing, we’ve taken some time to summarize the pros and cons of these target-date funds, and what they can and can’t do for plan sponsors and their participants.
How Target-Date Funds Work
At their core, target-date funds are simple hybrid mutual funds that take a “glide path” approach to asset allocation. Based on a selected retirement date (say, 2030 or 2045), the glide path will specify an aggressive initial portfolio allocation that gradually shifts toward a more conservative allocation as retirement (the “target date”) approaches.
While the specific glide path will vary widely from one fund to another (some are basically flat over time but become suddenly very steep in the latter years; others have a more constant slope), the typical “aggressive” allocation will consist of something resembling 80% stocks, 20% bonds, with a pre-determined shift over time to a more conservative allocation approximating 20% stocks, 80% fixed-income securities.
Note that the glide path does not get to a fully “conservative” allocation until after the retirement “target date”—a 50-50 allocation can best be considered moderate, not conservative. While this dynamic is in keeping with industry best practice, it runs contrary to the expectations of some investors, who may expect to be fairly conservatively invested by retirement.
Why Sponsors (and Participants) Like Them
Obviously, the greatest allure of target-date funds to plan sponsors is that they quickly and easily satisfy one of the major ERISA requirements, that of having a proper QDIA. The simplicity of target-date funds helps to streamline plan management, while also more easily allowing for automatic enrollment of employees as well as proper direction of employer matching funds.
This simplicity also appeals to plan participants, many of whom are not particularly sophisticated or knowledgeable when it comes to investing. Research from AllianceBernstein suggests that the presence of target-date funds in a 401(k) plan increases overall participation rates, as employees have a quick and easy way to allocate their plan assets. Per that research, as many as 60% of eligible employees would be more likely to participate in their plan if target-date funds were offered.
The fact that including target-date funds helps to encourage participation is another indication that they are, at least theoretically, operating in participants’ best interests, which is the goal (and requirement) of all plan fiduciaries.
Asset Allocation May Not Be Optimal
However, not all target-date funds are created equal, and plan participants are rarely equipped to judge whether the target-date fund that’s been selected for them is actually a good one for their investment goals and risk tolerances. Many investors would be shocked to find out what sorts of assets they own (or don’t own) when they look under the hood of their plan.
Industry research suggests that a properly diversified portfolio should contain between seven and nine asset classes in order to optimize risk-adjusted returns over time. But by their purest definition, target-date funds need not include any more than two asset classes. Yes, some certainly contain many more, and many of the funds are in fact very well diversified across asset classes. But the “target-date” label on the package doesn’t require it, and investors shouldn’t implicitly assume that their plan’s target-date fund is one of the lucky ones.
There is, ultimately, a lot of room for interpretation when it comes to manager choices within these funds, and how many asset classes to use is one of the biggest decisions a manager has to make. Perhaps not surprisingly, this lack of uniformity within the target-date fund world leads to some widely disparate outcomes for investors. In 2012, for example, Morningstar research found that the spread between the best-performing 2045 target-date fund and the worst-performing 2045 target-date fund was a whopping 7.5 percentage points (with JPMorgan’s JSAAX clocking an 18.1% return compared to 10.6% for Franklin Templeton’s FTTAX).
Some research even indicates that the target-date fund “glide path” may actually underperform compared to a simple 50-50 balanced fund, even though the average allocations over time are theoretically identical (assuming a typical 80-20 to 20-80 glide path), with only timing differences at play.
Perhaps most concerning are the wide misconceptions that investors hold regarding these funds. According to a recent SEC study, 41% of target-date fund investors chose them because they seemed like “safe” retirement vehicles, apparently not realizing that an 80%-90% stock allocation qualifies as aggressive by just about any measure. In the same study, only 36% of those investors were able to identify the fact that target-date funds do not provide guaranteed income in retirement.
On average, it seems that target-date fund investors expect these funds to be much safer (and better diversified) than their underlying investment approach actually suggests. For risk-averse investors, this can be a particular problem, as their retirement asset allocation may not fit into their overall financial plan. This mismatch likely reflects a failure of education on the part of plan sponsors and custodians, and it may indicate a broader failure to act in the “best interests” of plan participants.
Fees May Be Higher
In addition to being more aggressive than many investors appreciate, target-date funds may also carry higher fees than participants realize or desire. While growth in target-date fund assets has afforded certain economies of scale, bringing average fees lower in recent years, research from the Investment Company Institute suggests that the industry-wide average for target-date funds still clocks in at 0.58% annually, well above the level of many other mutual fund options.
As is the case with asset allocations, expense ratios vary widely from one target-date fund to another, without much rhyme or reason behind the differences. On average, though, with a 0.58% average fee ratio, an investor could almost always be saving money by constructing a self-directed diversified portfolio. And these fee drags can be quite significant, particularly when compounded over a long time horizon between prime working years and retirement.
Over a 30-year period, the difference between a 0.25% fund fee and a 1.00% fund fee can amount to almost 25% of the overall investment return; even the difference between a 0.25% fee and a 0.50% fee can cause a 7% drag over time. Unless the fund managers are particularly skilled (and over a 30-year period, there may be many different managers with different styles), this can be a hard hill to climb for an investor.
Participant Education is Still Vital
Ultimately, a plan sponsor should not assume that simply satisfying the QDIA requirement will also, by definition, satisfy the other elements of the “best interests” requirement of plan fiduciaries. Selecting an adequate QDIA is simply the first step toward designing a proper retirement plan for participants—in order to ensure that participants are properly invested to suit their individual goals, comprehensive education is vital. Unfortunately, most 401(k) investors report that they receive little or no investment education in the workplace, which leaves them extremely vulnerable to the pitfalls mentioned above.
Ultimately, there is a significant difference between simply satisfying legal requirements and actually meeting the “best interests” test for plan fiduciaries. Imagine a scenario in which a plan participant is currently paying 1.00% annually in fees in a target-date fund; his plan sponsor then hires an investment advisor to conduct participant education, paying that advisor 0.25% of plan assets per year. As a result of the education, the participant re-allocates his portfolio to an individualized portfolio that better matches his goals and risk tolerances, while also reducing portfolio-related fees to 0.50%. The overall costs to the participant have been lowered from 1.00% to 0.75%, all while better aligning his retirement goals to his investment approach.
While it’s probably unlikely that regulations would ever get so granular in their requirements of a plan sponsor (and it’s probably unreasonable to assume that a law would ever require a sponsor to hire an outside advisor rather than use a readily-available target-date fund), it should nevertheless be the goal of the sponsor to provide the best possible plan to his participants (and to himself, as the case may be!).
Target-date funds are an important part of a properly-designed retirement plan, and it should definitely be considered an industry best practice to include them in all plans to satisfy the QDIA requirement. However, these funds are far from a panacea for participants, many of whom are unwittingly putting their retirements at great risk with a plan that does not suit their investment goals.
Plan sponsors must ensure that the target-date fund they have chosen is a good fit for their participants, without passing on unnecessarily high fees. And as always, open and continuous dialogue between sponsors and participants is of the utmost importance.