Cover | Published in October 2006

One Size Does Not Fit All

Why risk-based funds fell out of favor in 401(k) plans, and ¬target-date funds got very hot

By Judy Ward | October 2006
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Why risk-based funds fell out of favor in 401(k) plans, and ­target-date funds got very hot

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 options."

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 Funds

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 20%.

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 says.

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."