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Responsibilities and Options to Consider When Selecting TDFs

By Justin Goldstein, AIF®, Director of Financial Wellness Services, Bronfman E.L. Rothschild


Target-date funds (TDFs), most often found in 401k plan lineups, but also available for college savings or retirement accounts, continue to be an attractive option for investors who might not have the time or knowledge to manage their portfolios and maintain appropriate allocations. Since their inception in the early 1990s, TDFs have become a major component among plan sponsors' extensive retirement plan offerings.

Recent Morningstar research shows TDFs are the preferred investment for U.S. employees' retirement savings.¹ Although growth of TDFs has slowed, they accounted on average for more than 30% of net new inflows to their respective fund firms in 2014, an 8% growth rate, according to the Morningstar report.

TDFs can be a good option for participants or individuals to stay properly allocated throughout their lives. But because they are designed for large numbers of investors -- hundreds of thousands may participate in a fund -- they can be a good choice for many but likely are not the best choice for every individual.

To determine whether TDFs make sense for your plan, consider your participant population. We have found there tend to be three basic groups: experienced investors who would like to create their own allocations; the inexperienced who prefer a single solution they can set and forget, such as a target-date fund; and those who are in between and would like help in creating custom, risk-based investment portfolios.

If many of your participants fall into the one fund/set-it-and-forget-it group, then TDFs should be part of your plan.

Employers and plan sponsors have responsibilities and options to consider when selecting TDFs. A key responsibility is to conduct due diligence, perhaps even more than is done for other available funds, precisely because so many participants will make this their sole election. Too often, plan sponsors evaluate and offer TDFs based solely on price, or they will use only the record keeper's series, especially if they are not working with an advisor. They fail to do any deep due diligence into the fund's holdings or glide path.

Plan sponsors can offer proprietary or open architecture TDFs. Proprietary TDFs are those in which asset allocation and manager selection are provided within the same fund family. Open-architecture TDFs can include funds from multiple fund families.

At first glance, TDFs might appear to be a simple, generic choice. But they can be extremely complex, partially because there are few constraints on the funds' design. For example, two funds with the same target date could have vastly different investment philosophies, asset allocations, and equity exposure at retirement.

We encourage plan sponsors to follow these steps when selecting TDFs:

  • Establish a process to compare funds before selecting which to offer to participants, to ensure there are good choices with appropriate allocations.
  • Conduct periodic reviews. Even if a fund "earned" its way into a sponsor's offerings, its performance should determine whether it stays. No fund should get a free pass.
  • Understand the fund's underlying investments. Evaluate the manager's process and approach to selecting investments.
  • Determine whether a TDF is a "to" or a "through" fund and the amount of equities present when the investor reaches age 65. A "to" fund gets investors just to retirement and may reduce equity holdings significantly at that point. A "through" fund assumes participants will hold the fund into retirement for several more years and may have more equity exposure.
  • Focus on the fund's glide path and how the fund's allocation will change as it approaches the stated target date to determine whether it's an appropriate choice to include in your offerings.
  • Develop a plan to inform investors about the pros and cons of the funds and how they perform.
  • Document how the plan selects and maintains target-date funds. Too many focus on price and ignore the rest of the details.

When determining which TDFs to select, there are a number of key attributes to consider and evaluate, some of which depend on the demographics among the participants. As a group, are they close in age or is there a wide age spread? Do they have most of their savings in the plan or do they have additional investments? Is a TDF more appropriate than a balanced fund or an alternate asset allocation option?

We scrutinize key metrics to evaluate TDFs, including the percent in equities when the target investor reaches age 65, the number of asset classes represented in the underlying funds, whether the fund's glide path is "to" or "through" retirement, the number of underlying funds, expense ratios and active versus passive exposure.

In some situations, we encourage plan sponsors to consider open architecture TDFs. No one fund family will have the best performing funds in every asset class and investment approach. Open-architecture TDFs can structure portfolios with best-in-class funds across asset classes.

A new strategy we've seen is for platforms to create custom glide paths and suggest funds to match, which can be a great solution for many participants. The downside is it requires participants to do the rebalancing necessary to maintain the guide path, but the upside could be potentially better performance with a best-in-class lineup of funds.

As the number of TDFs increases and the market becomes more crowded, it will be even more important for plan sponsors to work with an advisor to conduct thorough due diligence and select appropriate funds to ensure the best possible performance.

1. 2015 Target-Date Fund Landscape, Morningstar April 2015


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