Should You Use Target Retirement Date Funds In Your 401(k) Plan?

In a March 26^th letter to the Senate Special Committee on Aging, the Department of Labor announced that it was beginning an immediate review of Target Date Funds (TDF). TDF’s have become a popular option in 401(k) and other defined contributions plans as they offer to simplify investor’s decision making. These offerings are typically “funds of funds” meaning that they are managed using other mutual funds, usually from the fund family sponsoring the TDF. For example, Vanguard target date funds are managed using Vanguard funds as the underlying investment vehicles. They are managed to become more conservative (less stocks, more fixed income) as the holder approaches retirement. This relieves investors from having to make timing decisions regarding their portfolio.

While I agree with the concept of TDF’s, I have often been critical of the execution. My criticism has centered on three key issues.  The first and most critical is that there is no mechanism to match the investment allocation of a TDF to an individual investors risk tolerance. In other words, even though you and I may be planning on retiring around roughly the same time, we may not have the same tolerance for risk in our retirement investments. When investing in retirement date portfolios we are forced to accept what someone else dictates as an appropriate asset allocation and risk level for someone retiring within a certain date range. Which brings us to the second issue, opinions differ greatly on the appropriate risk level for any given time horizon. Hence there is an incredible amount of variation in the amount of equity (stock) risk between funds with the same target retirement portfolios run by different management groups. During our research for clients we have seen TDF’s from different vendors with the same target date differ in equity content by as much as 30%. The third problem is the fact that most individual investors really have very little idea of what they are buying when investing in target date funds or what’s in them. They simply fail to do the appropriate research.

Given the above issues, it’s not surprising that when an extremely trying market cycle occurs that a significant number of investors in target date funds are going to be disappointed in their results. I thought it would be helpful to share the protocol that I use to evaluate whether to recommend that clients use the target date funds available in their 401(k) plans.

1.       Determine the clients  risk tolerance

2.       Develop an asset allocation based on risk tolerance

3.       Develop a portfolio using the non target date funds available in the plan. Note that I have run across plans that are so poorly designed that it is not possible to design a properly diversified portfolio.

4.       If TDF’s are available in the plan, identify the fund whose asset allocation most closely matches the one developed from the client’s risk tolerance not the one whose target retirement date most closely matches the clients.

5.       Compare the past performance of the TDF with the performance of the portfolio assembled from the non-target date funds in the plan.

6.       If the TDF has consistently outperformed the portfolio put together using the non-target date funds or it is not possible to put together a decent portfolio using the non-target date funds then you should use the TDF. Note that past performance is no indication of future performance; it is however along with common sense, all we have to base decisions on.

7.       If we identify a TDF that looks like it might be an effective investment tool for that client, then we look at the underlying fund investments and check for diversification and management quality. One other issue with TDF’s is that some fund families have used them to gather assets for in house funds that have performed poorly and have difficulty attracting assets on their own.

This is the only protocol that properly evaluates all of the options available to a 401(k) plan participant. The bad news is that it represents a fair amount of work, more that most 401(k) participants are willing to do. The above protocol takes me about 4-5 hours and I have been doing research like this for over 20 years. Further, I know of very few plan vendors that supply plan participants with the research tools to follow the above protocol to make a rational and informed decision about the use of a target date fund, while my practice spends a great deal of money annually on independent research so we can make effective, unbiased decisions for our clients.

One of my pet peeves is people who write lengthy criticisms but offer no solutions. So if you are a participant in a 401(k) plan that offers target date options or you already own one, here’s what you should do.:

1.       Make the commitment to thoroughly understand the options in your plan. Use the protocol I have outlined above to evaluate the use of target date options in your plan.

2.       If you are unwilling or unable to make the commitment, seek out an independent, fee-only financial planner in your area and hire them to evaluate your plan and make recommendations. A good place to start your search is The Paladin Registry, an independent evaluator of planners www.paladinregistry.com .

For what it’s worth, here are some suggestions for the Department of Labor and The Senate Special Committee on Aging as they look into participant complaints regarding target date funds:

1.       Require a disclaimer on information of all forms accompanying target date funds that warns participants that the risk inherent in investing in a TDF may have no relation whatsoever with their own tolerance for risk.

2.       Set standards for information that should be made available to plan participants so that they can make informed decisions. This information should be readily accessible and streamlined so that plan participants do not need advanced degrees in economics, law  or finance to use or understand the material.

3.       Recognize, finally that not all plan participants want to, or are able to, make their own investment decisions and allow plan sponsors (employers) to be able to offer the services of independent, unbiased fee-only investment advisors without the fear of lawsuits provided that those giving advice have the proper credentials and training.