The Target Date Fund Trend: A Low-Maintenance Strategy

Are target date funds a clear 401(k) choice for advisors and participants?

According to the Investment Company Institute (ICI), mutual fund-based target date fund (TDF) assets climbed to a record $790 billion in Q1 2016 (up $27 billion since January), with TDFs in defined contribution plans accounting for nearly 68 percent of that amount.

“Target date funds are good for investors who don’t want to actively manage their 401(k)s,” says Michael Branham, CFP, an advisor with The Planning Center who also served as president of the Financial Planning Association. “They can be cost-effective while also providing access to a diversified allocation and professional management that might not otherwise be available to the average investor.”

With TDFs, asset allocations automatically become more conservative as the target date approaches. “Bottom line is that target date funds are a low-maintenance investment strategy,” Branham adds, which is appealing to many 401(k) participants.

ICI believes that target date asset growth is propelled by two factors:

• The TDF’s role as a qualified default investment alternative in plans with auto enrollment
• Participants’ willingness to assign asset allocation to these professionally managed options

Which investors are the most likely to select a TDF? Data from an ICI/Employee Benefit Research Institute study point to younger professionals and those in new jobs:

• 60 percent of 401(k) participants in their 20s held TDFs, versus 41 percent of participants in their 60s
• 59 percent of recently hired 401(k) participants held TDFs, versus 48 percent of 401(k) plan participants overall

Branham speculates that these numbers may indicate that younger participants without advisors prefer “do-it-yourself” investment options. Additionally, Branham believes that employee education is improving – and that when participants do learn about TDFs, they see them as an easy way to start saving for retirement.  

But are there downsides to TDFs?

Branham notes that, at a certain point, investors may want more control over their fund’s path. 

“You don’t get to choose asset classes in a target date fund, nor can you set the dates that it becomes more conservative,” he says. “If your life plans are on a different pace with a target date that was initially tied to your retirement, you have to potentially switch to a different date.”

These elements require thought, he says, but “the whole goal is not to think about it.”

It may seem obvious to include a TDF as a 401(k) savings option, but plan managers must recognize that in doing so, they’re not absolved of their fiduciary responsibilities and due diligence.

Bloomberg BNA reports that TDFs have recently come under scrutiny due to a lawsuit filed against Fujitsu Technology & Business of America Inc. that alleges plan fiduciaries “imprudently designed and implemented the plan’s target-date funds feature in violation of the Employee Retirement Income Security Act.”

According to the complaint, Fujitsu transferred a large majority of the plan’s assets into a set of customized TDF designed by a firm that had “no public track record of managing or designing target-date funds and used a ‘fundamentally flawed’ asset allocation.”

Most of the TDFs underperformed compared with their benchmark indices, the complaint states, and the scheme cost participants tens of millions of dollars.

TDF fees have consistently decreased over the past decade. While their expense ratio is still higher than that of ETFs or index funds (which also require the participant’s active management), says Branham, for an actively managed fund, TDF fees are quite competitive. “They aren’t the cheapest option, but they aren’t outrageously expensive anymore, either,” he says.

Though there is no surefire path to greater 401(k) participation, Branham has noticed TDFs have been eliciting more interest from both advisors and participants.  

“Target date funds provide a viable option for plan participants who might not otherwise save or who might ignore their 401(k) allocation altogether,” he says. “It’s more important that they save than which fund they choose.”