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.
The idea of the warning label is simply a disclosure to participants of the risk level of the portfolio into which they have been (or are about to be) defaulted. It can be as simple as giving them a table showing the composition of each portfolio, with the stock allocation percentage in bold, or simply a heads-up that the far-dated funds can have 85% or more in the stock market. They should be told that less risky alternatives are available. They should be encouraged to take a risk tolerance quiz and to match their allocation to the quiz result. And, they should be told that they are free to switch into a different “maturity” of the target-date fund array if a different one has an equity allocation that is more suitable.
On the other end of age spectrum, the near-dated target-date funds may also contain under-appreciated risks. Do your older employees understand that their target-date fund allocations may still contain stock allocations of 50% or more? And, since the balance of their allocation is largely in bonds, do they understand anything about duration risk? Many target-date funds have substantial holdings in longer maturity bonds. These existing bonds will lose value as rates move higher and newer bonds are issued with more attractive interest rates. The discount at which the older bonds will trade will be determined by the severity of the interest rate increase and the number of years at which the existing bonds are locked into the lower rate. Suffice it to say that significant disappointments are possible to participants who were uneducated about the risks in the portfolio that “the employer selected for them.”
Summing it up, the rules that created QDIAs were very generous with their liability protection for employers electing to use target-date funds in their plans. However, the opportunity exists to go beyond the minimum and to provide the education necessary to help employees (of all ages) to decide if they should opt out of the default investment and into something better suited to their individual situation.
In our experience, employees really appreciate this extra information. Little steps like this can turn a good plan into a great one.
Jim Phillips, President of Retirement Resources, has been in the investment industry for more than 35 years, the past 18 of which have been focused in the area of qualified retirement plans. Jim worked for major national investment firms for 14 years before “going independent” in 1990. Jim is an Accredited Investment Fiduciary, has contributed to two books on 401(k), and his articles have been published in Defined Contribution Insights, PLANSPONSOR’s (b)lines and ASPPA’s 403(b) Advisor, and Jim is a RetireMentor on MarketWatch.com. His work has been acknowledged with multiple Signature Awards from the PSCA, he has been named to the 2012 and 2013 list of Top 100 Retirement Plan Advisers, by PLANADVISER Magazine, and he was a finalist in 2012 for the Morningstar/ASPPA 401(k) Leadership Award. Jim has been a frequent speaker at national conferences, including SPARK, ASPPA, AAO and the PLANSPONSOR and PLANADVISER National Conferences.
Patrick McGinn, CFA, Vice President of Retirement Resources, is a CFA charterholder and has been in the securities industry since 1993. In addition to the Chartered Financial Analyst designation, he is an Accredited Investment Fiduciary and a member of the Boston Security Analyst Society. Together with Jim, Patrick has co-authored a number of articles which have been published in industry publications on topics about managing successful 401(k) and 403(b) plans. His work has been acknowledged with multiple Signature Awards from the PSCA, and he has been named to the 2012 and 2013 list of Top 100 Retirement Plan Advisors, by PLANADVISER Magazine. He was a finalist in 2012 for the Morningstar/ASPPA 401(k) Leadership Award.
NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.Any opinions of the author(s) do not necessarily reflect the stance of Asset International or its affiliates.