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What Every 401k Fiduciary Should Know About Target Date Funds

September 15
00:01 2010

(This is the third in a series of five articles on Target Date Funds)

Target Date Funds (TDFs) have been around for more than fifty years, but their popularity has soared since the Department of Labor (DOL) endorsed them as a default option under the Pension Protection Act of 2006. While one might ask why 1090780_60617770_dictionary_stock_xchng_royalty_free_300it took this product 50 years to become popular, a better question might be why had the product failed to spark much interest during those decades. A better understanding of the history, intent and the terms associated with TDFs may help the 401k answer these questions. This understanding may also allow plan sponsors to better assess just how TDFs impact their personal fiduciary liability.

History – Rich Lynch, COO of fi360, tells Fiduciary News “The DOL was under a lot pressure following the enactment of the Pension Protection Act of 2006. With the sustainability of Defined Benefit (DB) plans, Social Security, etc… called into question, the DOL felt the 401k was the only vehicle left to address retirement. They were feeling significant pressure to do something to give 401k participants a chance to maximize their returns by encouraging participants to move away from Stable Value and money market funds and into better longer-term investments like equities.”

Intent – From the Department of Labor (“Report On Hard To Value Assets And Target Date Funds”): “TDFs are being introduced because of the decline in the number of employers that are offering traditional defined benefit retirement plans. Participants are recognizing that they are responsible for amassing their own retirement income during their working years, yet they do not know how to invest, are not saving enough, suffer from inertia and fail to realize that those investments they do have, are not diversified. TDFs can help participants allocate their plan assets, a task done for them in a DB plan model. Additionally, fiduciaries and investment providers recognize that participants may not have the financial literacy to address their retirement needs. TDFs are a new means to assist participants (i) to address these issues, (ii) automate their investment allocations and (iii) hopefully achieve, the desired result of greater retirement account balances.”

Make-Up – TDFs consist of a portfolio with a dynamic asset allocation. The asset allocation generally includes the stock-bonds-cash categories most investors and fiduciaries are familiar with. As the TDF approaches its target date, the allocation changes to become more conservative. How fast this change occurs relative to the TDF’s target date depends on whether it’s a “to” or a “through” TDF.

Terms:

  • Benchmarking: This is how the TDF is measured. There are several competing methods of benchmarking TDFs, although all are of relatively recent vintage and, therefore without much of a substantial track record.
  • Expense Ratio: Like other mutual funds, TDFs have certain expenses bourn by the fund itself. These expenses make up the TDFs reported expense ratio. Many TDFs – the one’s more appropriately called a “Fund of Funds” – have additional expenses embedded in their underlying assets. While this “underlying” expense ratio can be shown in the TDFs prospectus, mutual fund data aggregators like Morningstar, Lipper, the Wall Street Journal and Yahoo:Finance show only the reported expense ratio, not the underlying expense ratio.
  • Glide Path: This term derives from the aeronautical term for the descent of a landing aircraft. In TDF terms, it represents the theoretical contribution/distribution time frame for the investor. TDFs also adopt a similar investment strategy based on either a “to” glide path or a “through” glide path and this determines how the TDF’s asset allocation will change over time.
  • “To” Glide Path: In general, a “to” TDF reaches its most conservative asset allocation on the target date identified in its name.
  • “Through” Glide Path: A “through” TDF usually won’t reach its most conservative asset allocation until some 10-20 years after the target date identified in its name.
  • Lifecycle, Hybrid, Balanced: These have all been used synonymously with “Target Date Funds,” but some firms define them differently (e.g., a “lifecycle” fund might be risk oriented, not date oriented; a “balanced” fund might have a fixed asset allocation; and a “hybrid” fund merely contains mixed assets).
  • “Set it and forget it:” A popular description for TDFs, as in “you just set your 401k allocations once and forget them until you retire.” Some view this as a derisive term.
  • Underlying Assets: TDF portfolios may consist of individual stocks, bonds and cash that make of the TDF, just lost any other mutual fund. Many TDF portfolios, however, contain only other mutual funds. These TDFs are called a “Fund of Funds” as a result of their underlying securities being other mutual funds.

The above represents just some of the terms 401k Plan Sponsors should know about TDFs. Please feel free to add others in the comment section below.

Like this article? You might be interested in reading other articles in this series.

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About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

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