Do your DC plan’s target-date funds need another look?
November 30, 2022
Target-date funds, or TDFs, can have a powerful influence on plan participants’ retirement savings by simplifying investment decision-making. And when TDFs are carefully selected to match with plan participant characteristics and behaviors, they have the potential to help more participants achieve greater retirement security.
That’s why TDFs are a popular choice for a qualified default investment alternative (QDIA) for 401(k) and other defined contribution plans.
But when a TDF is not well-aligned with plan participants’ demographics and behaviors, the plan sponsor may inadvertently expose participants to riskier investments than they intend to—a critical issue for plan fiduciaries—or participants may miss out on upside potential. So it’s important to consider more than just fund performance and fees when evaluating TDFs.
Plan fiduciaries should evaluate how well a TDF aligns with plan participants’ ages and probable retirement dates; in addition, sponsors should consider plan population demographics like overall earnings, employee turnover, contribution levels, hardship withdrawals, and other factors.
One key behavior sponsors and advisors need to consider is the plan participants’ 401(k) withdrawal patterns. Demographic factors can contribute to whether participants tend to withdraw large sums at retirement—or draw down their accounts more conservatively over time. That choice, however, can be a critical factor in a TDF’s level of risk to participants. Sponsors and advisors need to make sure they understand the interplay between participant demographics and behaviors, and TDF investment allocations and glide path structures.
Understanding TDF fundamentals
As fiduciaries, sponsors have a duty to understand not only TDFs in general, but also the specifics of the funds they select.
TDFs are structured as mutual funds that base investment allocations on participants’ ages or projected retirement dates. They’re generally designed to meet the needs of an “average” investor. They typically have a structured glide path that makes a gradual shift in allocation from more funds in equities earlier, toward more funds in bonds and cash as participants near retirement.
TDFs are often offered as an “off-the-shelf” option, structured as a “fund of funds.” Many plans choose off-the-shelf TDFs as a one-stop solution, and for some plans—but not all—they can be a good match. The key, of course, is that gearing a fund toward an “average” investor can lead to a poor match for participants who may be of similar age but who face varying financial situations.
Besides retirement dates and ages, plan participants can have widely varying earnings and other characteristics that impact levels of employee contributions, frequency and amounts taken out as hardship withdrawals and turnover, all of which can impact outcomes. More customized funds can be designed for plans whose participants have specific needs that off-the-shelf plans may not meet.
Key considerations for evaluating and choosing TDFs
Plan fiduciaries periodically review TDFs against the needs of current participants and assess whether adjustments are needed to meet changing circumstances. For example, company growth or contraction can change plan demographics, business strategies can change plan objectives, and TDFs can experience changes to management strategies or fund structures.
Fees and other TDF expenses
Fee types and amounts can vary a great deal from one TDF to another, and the difference can significantly impact retirement savings outcomes for plan participants. And there could be more than just the TDF fees. If the TDF invests in other funds (and they often do), sponsors and advisors need to know what the total fund expenses will be, taking into account both TDF fees and fees associated with its underlying investments. Plan advisors can be a valuable resource in ensuring all parties understand all fund costs.
Think beyond performance and fees
Fund costs versus historical performance are certainly important, but sponsors and advisors need to evaluate for a fit between the TDF’s glide path characteristics and their individual plan demographics. While fees and other expenses are fundamental, cost is only part of the cost-benefit analysis. Lower-priced funds may not be structured or managed to meet participants’ demographics and behaviors. Overall value is a more important consideration than dollar-for-dollar fee comparisons.
Investment allocations and glide path structure
To understand an off-the-shelf TDF’s investment strategy and associated risks, sponsors should ask how a fund allocates investments in stocks, bonds and cash, and make themselves familiar with the individual investments underlying the fund. Many TDFs are proprietary offerings, using only mutual funds from one fund family rather than using high-quality mutual funds from multiple fund families. Find out by reading the prospectus and/or other materials provided by the fund.
TDFs’ glide path structures can vary a great deal, too—and this represents an important fiduciary duty for plan sponsors. Compare the shift in investment strategy against the typical plan participant’s retirement withdrawal behaviors. TDFs that keep higher proportions of investments in more volatile assets such as equities may present more risk than participants are prepared to handle if they tend to withdraw a greater portion of their funds soon after retirement. A more conservative TDF may offer a better fit.
Is a customized fund a better option?
Some sponsors decide that custom TDFs are in their plan participants’ best interests. Custom funds can enable sponsors to offer glide paths that align more closely with their participant population—or even multiple glide path options for different employee demographic groups to choose from. Custom TDFs are non-proprietary funds that can allow for multiple fund managers and varying investment approaches. They can even combine actively managed investment portfolios with index funds.
In choosing between off-the-shelf options or a custom TDF, it’s hard to overstate the importance of consulting with your financial professional. Many plans have demographics that make off-the-shelf TDFs a great fit; others need a more tailored offering. The guidance of a plan advisor is critical to help sponsors make confident decisions that support retirement readiness for employees.
You are accountable to participants
In addition to careful fund evaluation and decision-making, plan sponsors and advisors should ensure participants have access to complete information about TDFs.
Education is important to help employees understand these funds in general terms—but advisors can also help sponsors make sure participants understand the specifics about:
- investment allocations
- relative risk
- fees and other plan expenses
Disclosures also need to explain that TDFs are not guaranteed; participants may lose money, even after reaching the fund’s target date.
At Cuna Mutual Group, our objective is to help more people achieve a secure financial future, so we’re committed to helping all plan stakeholders—advisors, sponsors and participants—achieve their objectives. Learn more about the ways we help support plan success. Contact us today.