“Target date funds are taking over.”
So says a recent article in Barron’s magazine, which then goes on to note that this asset class has grown from $160 billion to $670 billion from the end of 2008 to the present.
That’s an impressive rate of growth, to be sure. Vanguard, which manages over $600 billion in defined contribution plan assets, reckons that 80% of new plan entrants will be invested solely in target date funds, or vehicles of a similar nature and structure, by 2018.
It may be tempting to jump on the target date bandwagon and use these as the default option for your 401(k) plan. But while target date funds have some clear benefits, they have negative attributes as well. It’s important to understand their uses and their limitations as you structure the menu of offerings for your plan.
What Are Target Date Funds?
The basic premise of a target date fund is that it offers a mix of assets — equities, fixed income and perhaps some alternative assets like commodities — in a single fund. The mix is geared towards a specific future retirement date (hence the name).
If you are 24 years old today and plan to retire at 65, you would invest in a “Target Date 2055” fund. If you are 54 and plan to retire at 70 then your fund will have a 2030 target date. Those two funds should be invested with different proportions of equity, fixed income and other assets, reflecting the growth priority of the longer-dated fund and the more imminent income and safety needs of the earlier target date.
An employee contributing to a 401(k) plan may view the benefits of a target date fund as clear: there is no need to figure out how much to allocate to each asset class – an exercise which can seem intimidating – because the target date fund does it for you. That’s one less thing to worry about.
Corporate 401(k) plan sponsors enjoy the ready availability of target date funds from large fund families like Vanguard, Black Rock or Fidelity. This simplifies the operational burden of plan management.
Drawback to Target Date Funds
For all their advantages, though, target date funds have some major drawbacks that should give plan sponsors pause before defaulting to this alternative.
Target date funds are a “one size fits all” proposition. Everyone with the same expected retirement date gets lumped into the same fund, regardless of individual goals, risk tolerance or other considerations.
That is an important caveat. No two individuals have exactly the same set of goals and attitudes towards risk. Lumping all your employees into the same fund does not allow you to provide choices that take these differences into account.
Imagine, for example, that you have two employees both of whom plan to retire in 2035, twenty-one years from now. One of those employees is currently 50 years old. She’s hoping to retire at 71 and she got a late start to making monthly contributions. She needs to maintain a careful balance between growth and capital preservation.
The other employee is 24 years old and wants to retire at 45. She holds a more aggressive outlook with a higher capacity for risk. (If she gets to age 45 and still doesn’t have the means to retire, she can still work for more years until she reaches her goal.)
Clearly, the same target date fund would not be appropriate for both employees.
You Have Choices
When target date funds first appeared they were somewhat novel: the one-stop alternative for a diversified portfolio wasn’t readily available through other vehicles. But in the years since, that has changed.
For example, consider an online retirement plan management service like Jemstep, an online investment advisor that gives your employees personalized, unbiased advice on how to invest their 401k and other accounts. It recommends an asset allocation and advises people on where to locate their assets to obtain maximum tax and other benefits. It evaluates and recommends funds using advanced portfolio optimization technology across multiple characteristics and attributes.
In short, Jemstep gives specific buy-and-sell directions so that your employees know precisely what moves to make. It can either be used alone, or to complement the services of a face-to-face advisor.
Jemstep can help your employees exercise more control over their retirement — even if they have no prior knowledge about investing. As a result, the need for target date funds becomes less relevant.
Target date funds have the potential to encourage Americans to save more for their retirement. But a well structured 401(k) plan will have other choices available, giving each individual employee the opportunity to invest in the way that is best for him or her.
Use Jemstep to give your employees guidance for a secure retirement.