Industry Voices

(b)est practices: Target-Date Funds May Need a “Warning Label”

August 1, 2014 ( - Many qualified plans utilize target-date retirement funds as default funds, the funds into which a participant’s money is invested if they have failed to provide their own investment instructions.

By PS | August 01, 2014
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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 you.

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 opposite effect.

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.