Tuesday, 6/25/14 – Why You Should Consider Not Offering Target Date Funds in Your 401(k)

According to a recent survey, 85% of 401(k) plan participants are confused about their investment options. Because of that, participants guess, go strictly off recent performance, put a little in every option, ask another nonprofessional like a coworker or spouse, or their uncertainty causes them to go more conservative than perhaps they ought to.

The industry has touted target date funds as the remedy for this. Judging from how many plans use them they have been a huge success. I THINK THEY’RE WRONG!

The concept is simple: choose a fund that matches as nearly as possible the participant’s retirement date and let the fund take care of the allocation and fund choices. Quick, easy, comfortable. Maybe that’s why target date funds are the #1 choice for participants, chosen by 85%.

Here’s the problem: they think they understand the funds better than they do. And, worse, the plan sponsor also thinks they know more than they do.

This came up in 2008-09 when many participants nearing retirement assumed their target date fund was conservative in its allocation. Instead, they found themselves down 30%-40% in a matter of months. Many participants pulled out and went to the stable value fund, the money market or bonds. They hurt their retirment and either cursed their luck or cursed Wall St. In fact, the problem was that they had a false sense of security because they did not understand the product they were invested in.

The “glide path” different funds use to change their allocation over time is often too aggressive close to retirement. In fact, one study shows that AT RETIREMENT the average target date fund has 2/3 of its assets in stocks or high-risk classes of bonds. That is too high for most people at that stage.

Why so high? Think about it. Advisors who know little about retirement plans or target date funds, which is the vast majority, compare the funds by how high their performance is. If you are a fund company, how do you boost performance? That’s easy, you allocate more to risk assets.

How many times will a target date fund that uses a 40/60 mix of stocks to bonds at retirement get chosen over one that is 67/33 and has higher average performance? Not nearly as often as it should.

A better alternative that I often recommend is offering a few models that are labeled according to risk and allocation, for example, “Moderate Risk – 50/50 Stocks/Bonds.” Now, a participant knows better what he is getting. With little effort, he can walk his risk down as he gets older or more conservative because this method is transparent and easily grasped.

The other advantage is that the model is made up of the other 401(k) funds that on average are probably better than the underlying funds in the target date fund that are all from the same fund family. And, if using index funds, the model may have a signficantly lower cost than the target date fund.

What’s in your retirement plan? And, who is advising you?

Dave Hoshour