Target date funds as 401(k) plan investment options have grown in popularity in recent years. Target date funds are mutual funds composed of a group of other mutual funds. They operate under an asset allocation formula that assumes a participant will retire in a certain year, and adjusts its asset allocation model over time. These funds are often designed to invest fairly aggressively initially and then gradually reallocate to become more conservative as it gets closer to that assumed retirement year (i.e, the target date).
Advantages of Target Date Funds
Target date funds are relatively easy to opt into and essentially allow participants—especially those who may not be financially sophisticated—to select these funds and then take a hands-off approach as the funds adjust its asset allocation as the participant works towards retirement age. Another advantage is that target date funds consider a participant’s age to create a diversified portfolio.
The QDIA Factor
Target date funds are one of the qualified default investment alternatives (QDIA) permitted under the Pension Protection Act of 2006. In fact, many 401(k) plans, including those with an auto-enrollment provision, use target date funds as the default investment option for participants. However, because target date funds are not the only QDIA option available to 401(k) plans, plan sponsors should exercise due diligence to ensure a target date fund is right for their participants. Some common criticisms of target date funds include:
- The “set it and forget it” nature of target date funds can lull participants into complacency with respect to understanding and monitoring investments. Participants’ financial circumstances vary and have implications for optimum asset allocation. Additionally, target date funds may become too conservative too fast for some participants.
- Target date funds often charge higher fees than other types of mutual funds because they will pass through the fees charged by the underlying fund options that comprise the fund, as well as its own management fees. As a result, participants often pay two layers of fees with target date funds.
- Target date fund portfolios generally diversify using asset classes that are typically non-correlated, meaning that when one asset class decreases in value, the other tends to go up. Stocks and bonds are considered non-correlated asset classes. However, sometimes they move in the same direction. While this can be good on occasion, it does not provide the intended diversification.
Responsibility of Participants
In 2013, the Department of Labor released guidance titled “Target Date Retirement Funds ― Tips for ERISA Plan Fiduciaries.” The Department of Labor has noted concern that participants who choose or who are defaulted into target date funds can become complacent about their retirement investments. Although target date funds can effectively put a retirement portfolio on autopilot, they often come with high fees that drag down their returns over time. The Department of Labor has warned that participants who are responsible for investing their individual accounts need to understand target date fund basics.
Plan sponsors and participants should study the Department of Labor’s guidance to make sure all parties understand the overall pros and cons of target date funds.