According to Morningstar, target-date funds (TDFs) attracted nearly $70 billion in 2015. Another research firm, Cerulli Associates, has predicted that 88 percent of new 401(k) contributions will go into TDFs by the end of 2019. As this market expands, new versions are appearing: the ‘custom’ TDF has been labeled the fastest growing segment.
The rise of custom TDFs is somewhat ironic, as these funds are meant to be one-size-fits-all for investors. TDFs are on the short list of qualified default investment alternatives (QDIAs). Department of Labor (DOL) regulations allow retirement plan sponsors to put contributions by plan participants who do not specify investment choices into a QDIA without being responsible for investment losses. That is a prime reason for the growth of TDFs.
Now that custom TDFs are emerging, they help to point out that ‘regular’ TDFs have cons as well as pros. If you invest in a TDF or if you are considering one, you should know what is inside the package, so you can decide on an appropriate strategy going forward.
As the name suggests, each TDF has a target date: 2030, 2035, 2040, etc. These dates are meant to indicate the year closest to a participant’s anticipated retirement date.
Example: Lynn Martin, age 40, begins a new job at a company with a 401(k) plan that includes a TDF series. She plans to retire at 65, so she chooses the TDF dated 2040, when Lynn will be 64.
A TDF typically will be a fund of funds. Thus, Lynn’s chosen TDF includes a variety of stock funds and bond funds, currently allocated in a manner the fund company believes is suitable for someone 24 years from retirement.
In this hypothetical example, Lynn’s TDF now has 60 percent invested in equity funds and 40 percent in fixed-income funds. TDF funds have a ‘glide path,’ decreasing the exposure to stocks as the target date nears. Lynn’s TDF might have 40 percent in equities and 60 percent in fixed income by 2040, providing less market volatility and more income for shareholders who are in or near retirement.
TDFs do not cease to exist at the target date. Instead, they continue on, providing shareholders with the option of cashing in for retirement expenses or staying invested, just as would be the case with any mutual fund. Some TDFs reach their most conservative asset allocation at the target date and remain there in future years. Many other TDFs, though, continue on their glide paths by reducing equity exposure for another five, 10, or 15 years and sometimes even longer.
Just as not all TDFs are alike, the same is true for participating employee groups. ‘Vocation and location’ can make a difference, Morningstar has asserted, when designing custom TDFs. A relatively young group of technology employees in Silicon Valley, for example, may well have a different approach to retirement planning than workers at an industrial plant in the Midwest. A company in the oil industry might better serve plan participants with a series of TDFs with less exposure to investments correlated with oil prices and energy stocks because employee job security in that industry is highly vulnerable to those trends.
TDFs can be customized in many ways, from tailoring the glide path to cherry picking underlying funds to including asset classes not found in standard TDFs. The constant, at least so far, is the expense involved in creating and administering custom TDFs. For now, custom TDFs are usually offered by companies with retirement plans holding at least $100 million of assets. As the concept evolves, custom TDFs may become available to smaller companies or even to specific employee groups within large firms.
No matter what type of TDF you might consider, look closely to see just how your money will be invested. Moreover, you should keep in mind that you can put together your own custom target date portfolio if you are willing to devote the time and effort to researching your own investments. Alternatively, you can seek a financial adviser with a proven record of developing individualized asset allocation strategies for clients as they head towards and through retirement.
Trusted Advice: Veering from the path
- If you are considering a TDF for professionally managed asset allocation, look at the current glide path. Are you comfortable with this mix of funds and the plans for the future?
- Keep in mind that a TDF can change its glide path. These funds generally lost heavily in 2008, when the financial crisis occurred, so many TDFs decreased their equity exposure.
- The TDFs that changed glide paths in 2008 may have missed some of the subsequent stock market rebound before moving money back into equity funds.