Target date funds have become the primary retirement investment vehicle for millions of American workers, with total assets surpassing $700 billion, according to Morningstar.
But while employers have embraced TDFs, exercising proper due diligence on these investments is often challenging for plan sponsors given the complexity of their design. As a result, low-fee passive TDFs can seem like a safe hedge against fiduciary risk. But the truth is that opting for passive management is no guarantee of fiduciary compliance.
“There’s a misunderstanding in the marketplace that a plan fiduciary has a duty to pick the lowest cost fund. That’s clearly not right,” said Jason Bortz, senior counsel at American Funds. “It’s important to think about cost and about long-term investment results. It’s important to think about how well-tailored a TDF is to a plan’s participants.”
For instance, when Carmela Elco, a senior ERISA consultant, advises clients on 401(k) plan design, she starts with a questionnaire that provides insights into a plan’s participants – their risk tolerances, investment timeframes and sophistication. She then looks for a TDF series that makes the right fit for the group based on the glide path, asset allocation, fees and other factors.
This method has led Elco to include active TDFs or hybrid TDFs – which incorporate both active and passive strategies – in two-thirds of her clients’ defined contribution plans.
“Fees are important. Fees need to be justified,” Elco, who works at Blue Prairie Group, a retirement and investment consulting firm, said in an interview with Capital Ideas. But “everything a plan sponsor does has to be in the best interest of employees.”
There are a number of reasons a plan sponsor might lean toward passive TDFs.
The ongoing monitoring of passive TDFs could appear easier and less time-consuming than the effort required in monitoring active funds. At the same time, a number of lawsuits have been filed in recent years alleging that 401(k) plans have paid excessive fees when lower-cost alternatives were available. Fear of being sued, coupled with the Department of Labor’s focus on the impact of fees on retirement savings, has led some plan sponsors to believe they’re taking on more fiduciary risk by offering active TDFs.
But while ERISA mandates that plan sponsors carefully evaluate the target date series they choose and act in employees’ best interests, it doesn’t lean toward any particular investment strategy as the more prudent choice for fiduciaries.
“The fiduciary responsibility is the same whether you go index or active,” Preet Prashar, senior research analyst with the DC practice at Pavilion Advisory Group, told Capital Ideas. “The target date selection and the ongoing monitoring should still be the same process.”
In fact, by choosing passive TDFs to hedge against fiduciary risk, plan sponsors may not be acting in the best interest of plan participants and may therefore unintentionally fall short of their fiduciary responsibilities. Plan sponsors who dismiss active TDFs may be limiting participants’ opportunity to capture above-market returns through active strategies.
“You need to be thinking about the plan and not about managing your own fiduciary liability,” Bortz said.
For instance, soon-to-be retirees who rely solely on passive TDFs for their retirement savings could be in for a rude awakening if the market drops.
“In declining markets, participants experience the full brunt of the decline in passive funds whereas a select group of active funds can provide resilience,” said Toni Brown, CFA and senior defined contribution specialist at American Funds. “Participants getting close to retirement will likely suffer more in a meaningful decline with a passive target date approach than with an approach from this select active group.”
The reality is, even passive TDFs involve a number of active investment management choices. Most prominently, the glide path that determines the allocation of equity and fixed income exposures over time is an active decision that can have a big impact on risk and return. Determining which asset classes should be used to then implement the glide path is also an active decision.
As the chart below shows, TDFs made up of mostly passive underlying funds can have a wide range of equity exposures at age 65 – the time at which participants are presumed to start making withdrawals. The equity allocations at 65 among these passive TDFs range from 26% all the way up to 55%.
Although target date funds can appear straightforward, they are complex and vary greatly. That’s where the benefit of proper evaluation comes in.
“Plan sponsors need to go through a thoughtful process. That’s true for all TDFs, whether they are passive, active or a combination of both,” Bortz said.
Fees are an important consideration in the selection of a TDF provider, but they are not the only one. Fiduciaries should consider other factors including glide path design, the ability to manage risk, and the potential to deliver above-average returns.
The following are five key questions to ask when evaluating target date funds:
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