Jay Czarapata, Senior Wealth Advisor Representative, Bronfman E.L. Rothschild
John Richards, Investment Research Manager, Bronfman E.L. Rothschild
Pension Protection Act Paves the Way for Target Date Funds
Over the past few years we have seen an increase in interest and adoption of Target date funds (TDFs) by plan sponsors in their retirement plan investment line ups. The Pension Protection Act of 2006 (PPA) gave plan sponsors the guidance and comfort they needed to incorporate automatic plan features such as automatic enrollment and automatic deferral increase into their retirement plans. More importantly, plan sponsors could now make target date funds the default investment option. The PPA encouraged retirement plan sponsors to offer default investment options more in line with sound retirement investing principles that invested in stocks, bonds and cash equivalents. Target date funds offer greater potential returns over a longer time horizon than a cash or stable value option. The legislation removed fiduciary liability concerns by allowing target date funds, balanced funds or managed accounts as qualified default investment alternatives (QDIA) in automatic enrollment plans. The PPA took important steps toward strengthening defined contribution retirement plans overall, but more importantly helping individuals save more for retirement.
Growth of Target Date Funds in Retirement Plans
As more plans adopt automatic enrollment features, more target date funds are playing a central role in retirement plan investment line ups and usage by plan participants. According to a report released in December of 2013 by the Investment Company Institute and the Employee Benefit Research Institute, 401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2012, the use of target date funds in retirement plans, specifically 401(k) plans, continues to grow. At the end of 2012, 41% of 401(k) participants held target date funds, compared with 39% in 2011, up from 19% in 2006. Assets in target date funds also increased. At the end of 2012, 15% of 401(k) assets were in target date funds, up from 13% in 2011, and 5% in 2006.
Target Date Funds Defined
Target date funds are mutual funds that invest in a mix of stocks, bonds, and cash equivalents with a portfolio that automatically resets or rebalances according to a selected time frame that is appropriate for a particular investor. Target date funds automatically rebalance to become more conservative (invested more heavily in bonds and cash equivalents vs. stocks) as an individual gets closer to the target date or retirement age.
For example, a younger worker hoping to retire in 2055 would choose a “Target 2055 Fund,” while an older worker hoping to retire in 2025 would choose a “Target 2025 Fund.” The 2055 fund would be more heavily weighted in stocks, and invest less in bonds and cash equivalents. Its longer time horizon allows it to ride out the ups and downs of market cycles over a longer period of time. Alternatively, the 2025 fund would most likely invest more in bonds and cash equivalents and less in stocks since it has a shorter time horizon. The 2025 fund would be less volatile because of its investments and would be less subject to less market fluctuations.
While the concept of target date funds is simple to grasp, plan sponsors need to be aware that there are many types of target date funds offered in the marketplace with differing investment strategies, glide paths, actively managed vs. passively managed approaches, fees, and fee structures. It is important that plan sponsors, as fiduciaries, understand these differences when selecting target date funds as investment options in their plan.
Benefits of Target Date Funds
Target date funds offer plan sponsors and their participants a number of benefits.
- Eases retirement investment decision making by offering a one-stop investment selection
- Simplifies saving for those who would like to put their investments on autopilot
- Offers professional management, built in asset allocation and ongoing rebalancing of their retirement portfolio
- For automatic enrollment plans, target date funds are a QDIA easing fiduciary liability
- Allows the plan sponsor to provide employees with an easy and simple investment choice
- Gives plan sponsors peace of mind that they are making an appropriate investment selection that will help employees save for retirement
Bronfman E.L. Rothschild’s Approach to Target Date Funds in Retirement Plans
We consider the addition of target date funds to a retirement plan investment line up to be an appropriate choice for many companies and their employees, especially those plans that offer automatic features. Although target date funds may not be the right investment option for all participants, they meet the needs of a sub-segment of participants. In our experience, plan participants fall into three types:
Self-Directed – Do It Yourselfers or “DIY” Participants
This is the engaged participant who does the research and has some understanding of investments and their options. We encourage these individuals to work one-on-one with an advisor to review their selections and follow up regularly to rebalance the portfolio to stay on track.
Advice Seeking - “Help Me” Participants
This is a participant that does not want to be defaulted into a target date fund or some automated selection that might not suit their needs. Instead, these individuals are looking to better understand their options and seek customized advice on their portfolios. Being able to work with an advisor one-on-one is critical for this type of participant.
Target Date Alternative - “Do It For Me” Participants
When we can’t get individuals to engage and participate in the planning process, we generally encourage a target date fund approach. Target date funds, while not ideal, are appropriate for those participants who need a simple and effective way to save. Target date funds simplify the investment process and are a good fit for this last type of participant. For more information about our approach to effective plan design and employee financial wellness, please refer to our white paper, Principles of Successful Retirement Plan Design: A Focus on the Employee’s Retirement Readiness, John Richards and Marc McDowell, 2014.
Shortcomings of Target Date Funds
One of the major drawbacks of target date funds is that, while they may be a simplified choice, their one-size-fits-all approach does not take into account an investor’s risk tolerance. In our opinion the biggest shortfall of target date funds is that they assume everyone has the same risk tolerance level. To counter this shortfall, we encourage plan sponsors to include core options, risk-based model portfolios and target date funds in their investment line up. When we meet with a plan’s participants, we then administer a risk tolerance quiz. We consider risk-based model portfolios to be an optimum choice for those participants that understand their risk tolerance level. Target date funds are a nice alternative for those participants that aren’t focused on risk, do not want to bother with understanding their risk tolerance or just want a simple “do it for me” solution. We offer plan sponsors not only a solid investment line up, but we help their employees understand the investment options and engage in the process.
Plan Sponsor Must Follow Fiduciary Principles When Choosing Target Date Funds
In February of 2013 the Department of Labor (DOL) issued guidance for plan sponsors on selecting target date funds for their retirement plans. At Bronfman E.L. Rothschild we realized that our own investment selection parameters follow the basic principles outlined in this guidance.
When we work with plan sponsors to select the appropriate target date funds for their retirement plan, we follow this process:
1. Create an investment selection process and document it
We work with plan sponsors to create and document an investment selection process that would include:
- Creation and administration of an Investment Policy Statement which would act as the framework for the process
- Gather, evaluate, and compare information about target date funds
The criteria for evaluation would include examining:
- investment strategy
- portfolio management team
- portfolio style (active vs. passive)
- glide paths (see definition below)
- designation of the funds as “to” or “through” retirement (see definition below)
- performance returns
- fees and expenses.
We also help a plan sponsor determine if a custom target date fund may be a better option for their plan. The selection process needs to be documented and reviewed on an ongoing basis. Investment committee members need to be part of the selection process and understand how it was undertaken.
2. Engage in periodic review of your investments, including target date funds
On a regular basis, plan sponsors should review all the investments in their lineup, including target date funds. Plan sponsors should assess if the target date funds are still appropriate investment options for their plan, if the specific funds chosen have had any performance issues, if they have adhered to their investment strategy, or if they have had any turnover in management, among other things. We would also recommend that the investment policy statement be used as a guide during the regular review process. We also advocate for quarterly monitoring of all investment performance.
3. Effectively communicate the target date funds to the employee population
A plan sponsor must understand their participant population, specifically the factors that may make target date funds an appropriate selection for their employees. For many, the inclusion of automatic features will make target date funds an appropriate choice. Plan sponsors need to help employees understand and engage in the investment options in their retirement plan, including the target date funds. How well employees understanding and engage is a sign of their overall financial wellness.
Target Date Funds: The Bottom Line
Target date funds make saving easier for plan participants. It is incumbent on the plan sponsor as a fiduciary to oversee the selection, implementation, and monitoring of target date funds.
The term glide path refers to a formula that determines the asset allocation mix of a target date fund, based on the number of years to the target date. The glide path creates an asset allocation that determines how the asset mix changes as the target date approaches. The glide path becomes more conservative (invests more in bonds and cash equivalents and less in stocks) the closer a fund gets to the target date. Each investment manager’s target date funds will have a different glide path. Some have a very steep path, becoming much more conservative just a few years before the target date. Others will take a more gradual approach over time. It is important for plan sponsors to evaluate glide paths when selecting target date funds for their plan.
“To” vs. “Through” Target Date Funds
It is important to know that there are two types of target date funds. One type of target date fund reduces its asset allocation to more aggressive investments until it hits the target date or retirement date. This fund is a “To” type of fund, meaning that when it hits the retirement date, it will be at its most conservative allocation, with a larger portion of the fund assets in bonds and cash equivalents and less in stocks. The other type of target date fund is a “Through” fund. It reduces its allocation, not to the target date, but to a point a number of years after the actual date of the fund. This type of fund assumes that the assets will need to continue to grow for a number of years after the actual date of retirement. It is also important for a plan sponsor to assess which type of target date is most appropriate for a plan and its employee population. If the employee population is likely to stay invested in the plan after retirement we generally recommend a “Through” retirement target date fund. It’s a more appropriate option for those employees who will wait longer for distributions from their retirement plans. For plans whose participants “cash out” at retirement to rollover their balance into an IRA or buy an annuity with their retirement proceeds, a “To” retirement target date fund may be a better option.