Their use can make sense, for a couple of reasons:
- The stock/bond allocations of target-date funds are based
upon age, and there is a certain logic to the idea that younger participants
should start with higher stock allocations than their older coworkers. Over time, as participants age, their stock
allocations are automatically reduced, and this makes sense as well.
- Generally, target-date retirement funds qualify as qualified
default investment alternatives (QDIAs).
QDIAs can provide liability protection to the plan’s fiduciaries.
If your plan has an auto-enrollment feature, a non-elective
safe harbor feature or profit sharing, you are likely to have a meaningful
number of employees whose balances will wind up in your default fund(s). That’s because you will be making deposits
for them without them having been required to make any decisions. That makes this topic even more relevant to
At this point, you may be wondering, “If target-date funds are logically constructed, and if they come with
special liability protection, then why are we talking about a warning label?”
In our experience, most employers want to do more than the minimum required to
keep their plan in compliance. They want
to get some mileage out of it as a key part of the employee benefit package,
and it makes good economic sense to help employees achieve financial
independence by retirement age. (We’ll
flesh this out in a future article, but the general idea is that older employees
become more expensive and many remain on the payroll because they can’t afford
to retire.) Target-date funds can help
people achieve their retirement goals, but for other people they can have the
Don’t get us wrong.
We’re not anti-target-date funds.
We use them extensively. The
issue we are concerned with is the lack of knowledge on the part of employees
about the risks involved. Whenever there
is a mismatch between one’s investment risk and one’s risk tolerance level,
there is the real potential for an economic disappointment. There is not currently a uniform mechanism for
communicating target-date fund risks to the people being pushed into them; hence
the suggestion of a “warning label.”
While there is logic in the idea that younger participants’
stock allocations should be higher than their older counterparts, the
correlation between age and risk tolerance is far from perfect. Studies, and
our own experience, have shown that large numbers of the Millennial generation
are quite risk intolerant. Yet, the
typical 2055 or 2060 retirement fund may have a 90% or higher allocation to
stocks. There is potential danger in the “we know what’s good for them”
approach. The danger is that a mismatch between risk and tolerance for risk can
lead to emotionally-driven decision errors.
Let’s remember that it’s been years since we
have seen a meaningful drop in the stock market. Anyone joining a plan since March 2009 has
enjoyed a generally pleasant ride on the current bull market. What’s going to happen to the risk-adverse
employees who were defaulted into stock-rich portfolios when the market gets
nasty? It’s likely that, without
effective communication (before and after the fact), droves of them will be
selling out after the next big drop,
and it may be years before they get back into retirement-saving mode.