Target Date Funds
WHY USE TARGET DATE FUNDS IN A RETIREMENT PLAN?
Professional money managers have long recognized the importance of asset allocation. Studies have shown that investment performance is mostly determined by a portfolio’s mix of stocks, bonds, and short-term investments, not individual stock and bond selections.
In many plans, busy or less confident investors often default to the most conservative investment options. In doing so, they may sacrifice the opportunity for wealth accumulation that most retirement investors should seek. That is why funds offering a range of predetermined asset mixes are ideal investments for participants in defined contribution retirement plans. By selecting a fund that is automatically rebalanced to follow a predetermined
allocation strategy, participants can rely on that single fund to maintain the desired asset mix.
SHOULD PARTICIPANTS USE TARGET DATE FUNDS AS THEIR SOLE INVESTMENT?
Target date and asset allocation funds are generally designed to be the sole investment for the retirement savings of experienced and novice investors alike, although they can also serve as the core of any portfolio.
WHO IS A GOOD CANDIDATE FOR TARGET DATE FUNDS?
Target date funds are well suited for the participant who may feel overwhelmed or not educated enough when it comes to choosing the direction of investments in their 401(k) plan. Target date funds correspond to an investor’s target retirement date, or the year in which the investor plans to begin withdrawing money from the portfolio. Target date funds relieve the participant of having to choose and monitor the investments on their own. Providers of target date funds manage the funds, rebalancing and adjusting them to offset market fluctuations and a participant’s changing risk profile. Target date funds offer diversification across multiple asset classes, are adjusted annually to a more conservative mix of investments as the target retirement date approaches and have a set asset allocation strategy. This takes the guesswork out of the mix for the participant. The target date approach also eliminates the choice overload phenomenon that can result from too many options.
Target date funds are particularly suited to participants who want a diversified portfolio in a single fund, are inexperienced investors who prefer to have their asset allocation decisions professionally made and are looking for a time horizon or risk-based investment strategy with a single decision. Investors overwhelmed by too many funds from which to choose may make less-than-optimal decisions at best, no decisions at worst.
WHY DO TARGET DATE FUNDS MAKE A GOOD QUALIFIED DEFERRED INVESTMENT ALTERNATIVE (QDIA)?
When a participant fails to make an investment fund choice for their 401(k) contribution, the plan fiduciary may be required to step in and make that decision, depending upon plan options. If the plan has approved QDIA, the plan fiduciary would invest that participant’s contribution into a default investment.
The Pension Protection Act (PPA) provided that QDIAs must include a mix of asset classes consistent with capital preservation or long-term capital appreciation, or a blend of both. And, a QDIA must meet the retirement savings needs of the employees. Three categories for investing participant’s contributions were established by the Department of Labor; age-based, risk-based and managed accounts. It was determined by the DOL that target date funds (TDFs) were appropriate since they take into account the age or retirement date of an individual and invest in a combination of US stocks, US bonds, and international stock index funds. Assets are allocated among these index funds according to a pre-determined asset allocation strategy.
The TDFs automatically rebalance to a more conservative strategy as the target retirement date approaches. Over time, the stock allocation of the funds decreases and the bond allocation increases. Once the retirement year is reached, the TDFs are then invested in a conservative mix of cash, bond, and stock investments
and will remain within this target allocation indefinitely.
TDFs are the most popular choice for QDIAs.