Why risk-based funds fell out
of favor in 401(k) plans, and Âtarget-date funds got very
What happened to risk-based funds? Adviser Tony Ciocca
has a simple explanation for why they have been spurned by
401(k) plans in favor of target-date funds.
"It is the whole trend toward the DB-ing of DC
plans," says Ciocca, managing director of
Institutional Investment Consulting Inc. "That is a
lot easier to do with these time-based funds than with
risk-based funds." Some purists still prefer
risk-based funds for 401(k) plans, says Dick Davies, senior
managing director, institutional defined contribution
services at AllianceBernstein L.P. "They believe it is
overly simplistic to treat all similarly aged participants
the same. With the risk-based portfolio, you can at least
tailor it broadly for participants," he says. "That point
of view is losing ground rapidly, though. Participants
really do not understand their risk preference, even with
some sort of educational materials or tools to guide
them—they are simply reacting to the choice presented to
them. A risk-based portfolio selected today will probably
not be the right portfolio in 10 years, but we know that
participants show incredible inertia and rarely change
Davies disputes the view of target-date funds as
harmfully simplistic. "People forget that the simplicity of
target-date funds is one of their greatest benefits," he
says. "Target-date funds are a simple, effective solution
that offers a significant improvement over portfolios that
participants would build on their own. We need to be
careful not to overthink the problem."
Target-Date Versus Risk-Based
Sources point to three main reasons why target-date
funds have become such a big deal. First, they require less
of participants up front than risk-based funds. "The
participants only need to match up their retirement dates
to the target date of the fund, and then they are
finished," says Matt Smith, managing director, retirement
services at Russell Investment Group.
"They are easier for participants to understand," says
Vincent Morris, vice president of retirement plan services
at adviser Bukaty Companies, "and they are easier for
sponsors to set up as a default, rather than guess
someone's risk-tolerance level." Most risk-based funds
use a risk-tolerance questionnaire to get participants
started, he says. However, with most only asking around a
half-dozen questions, he adds, "I do not think they are
detailed enough." It also can be hard on these
questionnaires to get participants to clarify their
feelings about scenarios like losing 5% versus losing
Participants have trouble pinpointing their own
risk-tolerance level, since most do not label themselves as
conservative, moderate, or aggressive investors, says Scott
Gilmour, senior vice president, investment services at
Fidelity Employer Services Co. "These are things that they
do not necessarily understand. Younger participants,
especially, would not know how to classify themselves.
Age-based funds take that issue away."
The second reason: Participants in risk-based funds have
to take the initiative to shift themselves into
less-aggressive portfolios over time. "With a risk-based
fund, as you get closer to retirement, you need to pull out
of the growth model, then to moderate, then to
conservative," says Gregg Andonian, president and CEO of
Baystate 401(k) Advisors. "A target-date fund automatically
migrates you into the model you need."
If a 30-year-old participant picks an aggressive fund,
that person will stay in the aggressive portfolio until he
or she proactively goes in and changes it—an iffy
proposition that could have bad consequences later on in
his or her career, says Chad Larsen, senior vice president
and adviser at Moreton Financial Solutions/NRP. "We are
starting to realize that most participants are very passive
with their accounts."
Third, some sources claim that providers promote
target-date funds heavily in part because they produce
bigger profits. "In the education process, they are pushing
target-date funds—tremendously so," says Chris Lee, senior
vice president at Wachovia Securities, "but I have never
been a fan of these target-allocation funds. For the most
part, they are proprietary: They are using their own funds
and, in some cases, they are using their own funds and
putting a wrap fee on top of it. They are in the business
of making money, and utilizing the proprietary funds is
where they are going to make the most money."
Some providers use these types of funds "to drive
revenues to underlying funds that nobody in the market is
going to," Andonian agrees. "Plan sponsors need to be very
conscious of that. Where are those assets ultimately going?
If you are using a fund of funds, money may be going to
underlying funds that, if they were in your 401(k), you
would have on your watch list."
With target-date funds so popular, some believe,
risk-based funds appear likely to fade into obscurity. "In
my opinion, it is an idea whose time has passed," says
Kevin Crain, director, institutional product sales at
Merrill Lynch Retirement Group. "Risk is an important
consideration, but targeting an end result for the
individual seems to be the better way to go."
Others see a possible niche role for risk-based funds.
"There is an interim kind of investor who is not active
enough to choose his own investments, but who is active
enough to want to know what his risk level is," Ciocca
These funds could make sense for companies confident
about their participants' ability to make the necessary
shifts proactively as they age, Larsen says. "There is a
place for risk-based funds," he says. "The challenge is
that we have kind of gone down the road for employers or
other fiduciaries to pick either/or, and most opt for the
target-date funds because it is one-stop shopping."
Sponsors offering both target-date funds and risk-based
funds run the risk of adding to an already-overwhelming
investment decision, he says.
Employers such as professional-services firms that have
an unusually large percentage of highly paid employees
could justify having both, Davies says. "However, there is
evidence to say that very few plans have the need for both
because of the confusion and the broader trend to
streamline investment offerings."