For many employees and employers, the target date funds (TDFs) in their 401(k) plans can’t do them wrong. The concept of simply choosing a fund which relates to your approximate retirement date, then having the asset allocation decisions left to the professionals has an enormous appeal. But as a fiduciary to your plan, that does not mean you are safe from simply offering any TDF line-up your fund provider offers you.
The U.S. Department of Labor made that clear.
Background: Callan Associates, the financial research and consulting firm, reports that in 2012 a majority of participant contributions (the funds in their DC index) went into target date funds. They now have 16 percent of defined contribution assets. “It is only a matter of time before the target date funds claim the biggest slice of the DC asset allocation pie,” the firm reports.
The Labor Department’s Employee Benefits Security Administration warns that because fundamental variations among TDFs are so significant and impact performance, “it’s important that fiduciaries understand these differences when selecting a TDF as an option for their plan.”
Here is a summary of what the Labor Department wants plan fiduciaries and employers to do:
Set a formal process for picking and comparing a target date fund. This process should help enable you to assess the prudence of any investment option made available under your plan.
Beyond checking on how well the TDF’s characteristics align with eligible employees’ retirement dates, “it’s also helpful for plan fiduciaries to discuss with their potential TDF providers the possible significance of other characteristics of the participant population, such as participation in the traditional defined benefit pension plan offered by their turnover rates, employer, salary levels, withdrawal patterns, and contribution rates,” according to the Department of Labor.
Try to Establish a process for the periodic review of selected target date funds. Plan fiduciaries are required to review the plan’s investment options often to make sure they can continue to be offered, the guidance states. “At the least, the review process should include examining any major changes in the information fiduciaries considered when the option was last reviewed or selected.” Sometimes a TDF’s management team or investment strategy changes significantly. If that is the case, and you don’t like the change, “you should consider replacing the fund altogether.”
Understand your fund’s investments. What are they, and how will they change over time? “Make sure you understand your fund’s glide path, including when the funds will reach the highest conservative asset allocation and whether that will occur before or after the set target date.” Some TDFs assume employees will keep holding to those TDFs for the rest of their lives, and others assume they will re-invest their funds when they retire. “If the employees do not understand the fund’s glide path assumptions when they invest in them, they may be surprised later if it turns out not to be a good fit for them.”
Review investment expenses and fees. It should come as no surprise TDF costs can change significantly, both in the types of fees and amount. “Small differences in investment costs and fees can have a big impact on the reduction of long term retirement savings.” (However, fees are not the sole determinant of net performance.) “If the TDF invests in other funds, you will need to consider the expenses and fees for both the TDF and the underlying funds?” the Labor Department asks.
“Added expenses could be for asset allocation, re-balancing, and access to special investments that can smooth out returns in uncertain markets, and maybe worth it, but it is important to weigh the options.”
Consider whether or not a custom TDF would be a better fit for your particular plan. The Labor Department states that some TDF vendors use only their own funds as the TDF component investments. But sometimes, a customized TDF may offer advantages by giving you the ability to incorporate your plan’s existing core funds in the TDF. “Non-proprietary TDFs can also offer advantages by including component funds that are managed by fund managers rather than the TDF provider itself, in turn diversifying participants’ exposure to one investment provider.”
Develop effective employee communications. “Just as it is important for the plan fiduciary to understand TDF basics when choosing a TDF investment option for the plan, employees who are responsible for investing their individual accounts need information too,” the Labor Department states. What employees must receive is already mandated, such as fee disclosure rules that started in August 2012. Those rules include expense information and specific fees regarding their TDFs and other investment options available under your plans.
Document the process. As with other investment decisions, “plan fiduciaries should document the review process and selection, including how they got to decisions about their individual investment options.”
What is a Glide Path?
You may be familiar with the term “glide path,” when it comes to flying. In this instance, it refers to the descent of a plane guided by a radar beam. The beam provides direction so that the plane can land safely at its intended destination.
As a plane is in the air, it requires adjustments over time — weather, speed, proximity to the ground, direction, geographical barriers like mountain ranges — to ensure it reaches its intended destination.
The glide path of a target date fund requires methodical adjustments similarly, becoming more conservative as the retirement date draws in. This may include a mix of assets with a large amount of equity for a longer, presumably smoother approach to the retirement date. Other TDFs might include a steeper path, flying higher, with a bit more risk for a longer time, then becoming significantly more conservative when the landing is in sight.
For a plane or a target date fund, it’s all about the approach. How long is your horizon?
The complete version of the Department of Labor guidance can be found here.
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