A previous article in our May 2017 newsletter addressed how a poorly designed investment menu can negatively impact a plan’s participation rate and the asset allocation decisions made by participants. Most participants are not investment experts, so it becomes a daunting task for them to have to choose from the funds on their 401(k) investment menu. Often, this results in a paralysis that stymies participants from participating. Or, if they do sign up, the decision of how to allocate their contributions is so bewildering that they end up with inappropriate allocations. Target-date funds (TDFs) are one of the innovations intended to help mitigate such problems. This article will provide some background on TDFs and highlight their positive attributes.
TDFs have been around since the 1990s, but their usage in 401(k) plans really took off when the Pension Protection Act (PPA) of 2006 gave them status as a Qualified Default Investment Alternative (QDIA). As automatic enrollment features proliferated, TDFs became the QDIA of choice for most plans. This helped drive explosive growth in their utilization. In Vanguard’s most recent report on DC plan data for plans they manage, “How America Saves 2017,” data illuminates the growth in the number of plans offering TDFs, the number of participants using TDFs and the amount of contributions going into TDFs. For example, the following increases were noted:
- Plans offering TDFs – 58% (2007) vs. 92% (2016)
- Assets in TDFs – 5% (2007) vs. 28% (2016)
- Contributions into TDFs – 8% (2007) vs. 49% (2017)
- Participants using TDFs – 18% (2007) vs. 72% (2017)
Furthermore, the participants using TDFs are skewed towards younger employees, seemingly an indication that assets in TDFs will continue to increase.
How TDFs Work
TDFs are “all-in-one” funds; they are intended to be well-diversified, age-appropriate allocated portfolios. The diversification is achieved by a “fund of funds” (FOF) approach, where the TDF invests in several mutual funds representing various asset classes. The most common TDFs are issued by mutual fund families, such as Vanguard and Fidelity. The target date is specified in the fund name and represents the date closest to the date the investing participant expects to retire. For example, TDFs come in a series, generally in five-year increments (e.g. Vanguard TDF 2020, 2025, 2030, etc.). The diversification and allocation are determined by the TDF’s investment manager. A “glide path” is utilized so that the fund’s allocation to equities is gradually reduced and the allocation to fixed income is increased. The intent of the glide path is to reduce the risk of the fund as the target date is approached.
Benefits of TDFs
Possibly the most compelling aspect of TDFs is how easy it is for participants to make a fund selection. They just need to pick the target year closest to their expected retirement year and they’re done – nothing left to do. The professional management of the TDF is another positive attribute. The TDF is an “all-in-one” fund, so the participant doesn’t have to make any allocation decisions or even understand how the allocations work. These two features address the issues discussed at the start of this article, relating to employee paralysis and poor asset allocation decisions.
While these features clearly help participants, the plan sponsor benefits from a potential reduction in its fiduciary exposure. The intent of providing for QDIAs in the PPA was to encourage the investment of employee assets in appropriate funds for long-term retirement savings. The legislation and regulations provide some protection to plan sponsors if their designated QDIA complies with the appropriate requirements, thus potentially reducing their fiduciary liability in the event of investment losses.
This article has highlighted the benefits and positive impact that TDFs have had for participants and DC plans in general. They have made investment decisions easier for participants by providing a one-click professionally managed fund. TDFs have also played a role in improving employee participation in DC plans. Finally, plan sponsors potentially enjoy some relief from fiduciary exposure.
In our next newsletter, we’ll investigate some potential shortcomings of TDFs and introduce you to an innovative new offering, a target date income fund, which is meant to address these shortcomings.
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