Using Target Date Funds to Achieve Retirement Readiness

Most plan sponsors don't provide traditional pension plans anymore. But that doesn't mean they can't give employees the tools to pursue an age-appropriate investment strategy that leaves them with sufficient savings for a secure retirement—they just need to find other ways to do it.

Target date funds (TDFs) are fast becoming the preferred method. Over half of plan sponsors currently offer TDFs as a defined contribution plan option, and that figure is expected to top 85 percent in the next year, according to a recent Institutional Investor survey conducted in partnership with Prudential. Consultants and advisers, as a group, strongly recommend TDFs, the survey found—ahead of any other investment category. TDFs are especially well suited to employers with a young workforce, many of whom may be disengaged from the retirement saving process, consultants say. This is a serious problem: 59 percent of plan sponsors are concerned about the impact of not starting to save early enough on employees' financial health and retirement security. “TDFs bring something that traditional balanced funds didn't,” says Ryan Gardner, managing partner and senior consultant at Fiduciary Investment Advisors, “which is a recognition of where each individual participant may be on the path to retirement and how that relates to their asset allocation.”

Money is piling up rapidly in TDFs, largely driven by plan sponsors with automatic enrollment who now commonly pick TDFs as their qualified default investment alternative (QDIA). While they are often seen as the designated offering for employees who are not as savvy about investments, their popularity may be much wider. “We have a really good, highly educated, informed group of employees who make good investment decisions on their own,” says Natasha Taylor, director of global benefits at BMC Software, a high-tech company with 401(k) plan assets of $700 million, about half of which are invested in the plan's TDF series.

The glide path determines whether the investment mix matches the demographic of the employer’s workforce. That makes glide path structure by far the most important factor when plan sponsors evaluate and pick a TDF, both plan sponsors and consultants said in interviews. Regulators recommend that plan sponsors take a close look. “Make sure you understand the fund’s glide path, including when the fund will reach its most conservative asset allocation and whether that will occur at or after the target date,” the Labor Department's TDF tip-sheet says.

Other factors carry weight as well. “Glide path, range of asset classes and fees are the big three,” says Jennifer Flodin, defined contribution practice leader at Pavilion Advisory Group. And, since many TDFs now have a fairly long history behind them, a deeper dive is possible. Pacific Life Insurance Co., with close to $1 billion in 401(k) assets, looks at the tenure and track record of the people managing the component funds, says Patrick Paynter, group retirement analyst. When Sandia Corp., with $3.2 billion in 401(k) assets, reevaluated its TDF in 2014, Leah Mitchell, senior manager, retirement investment management, says the questions it asked its provider included: “Do they adhere to the structure with which they're supposed to be managing it? What's their risk level? Are they following their glide path, starting with their investment goals at different stages? We look at past performance—although that's not as important as these process points—and cost. If everything else is similar, then lower fees are an advantage.”

Since TDFs are a popular default option, it's also important for plan sponsors to review and reevaluate them regularly. “It's a natural thing to conduct due diligence in any investment group, but with the structure of TDFs, it requires extra attention, because plan sponsors want to make sure their default option is as robust as possible,” says Mark Teborek, consultant at Russell Investments. Our survey found that nine out of ten plan sponsors that offer them are likely or very likely to reevaluate their offering in the next few years; among the plan sponsors we interviewed, Brown-Forman and USG Corp. said they review their TDF series and provider at least once a year, while Sandia Corp. and Ford Motor Co. do so every three and four years, respectively.

TDFs enable plan participants to focus less on asset allocation and more on how much they need to be saving along the way, says Gardner. But that doesn't mean participants all have a perfect understanding of how TDFs work and what they are meant to accomplish. Educating participants about TDFs is still important.

“Some [participants] treat the TDF as separate mutual funds and actively manage their account by allocating among several of them,” says Donna Wimbec, senior manager of global benefits compliance at distiller Brown-Forman, which has $448 million in two 401(k) plans. “What they don't understand is that the same investments are in each, just in different allocations.” At one financial services company that changed TDF providers three years ago, some participants now have money in multiple TDFs as well as in other investments the plan offers. Communication efforts explaining that the appropriate way to use TDFs is to concentrate one's DC plan holdings in a single series have been received appreciatively, although they have not yet resulted in much movement.

While educating participants on TDFs can be difficult, doing so is only becoming more urgent, given the present uncertain nature of the markets. “The next wave of retirees will be the first to feel the effects of stock market volatility on retirement,” says Paul Denu, defined contribution practice leader at USI Consulting Group. Our survey found that over half (54 percent) of plan sponsors strongly agree that holding their DC assets in a TDF helps employees overcome risk aversion.

As a solution, some plan sponsors report that their consultants and advisers have suggested they reenroll all DC participants—not limited to new hires—in a TDF. Another approach that some plan sponsors and consultants suggest, often in conjunction with reenrollment, is to integrate a better understanding of TDFs into companies' efforts to educate employees on how to achieve financial wellness. Online calculators that enable the employee to determine how much he or she would need to accumulate to retire securely by a specific age are helpful, since they reinforce the need to adopt a glide path to getting there.

Data tools can also help the plan sponsor itself to stay on top of participants' behavior. Ford, for example, which has $14 billion in 401(k) assets, uses Tower Watson's FiT Age tool to gauge employees' savings behavior and retirement readiness.

Achieving financial independence is, of course, the employee's responsibility. But the stakes are high for plan sponsors as well; on average, our survey found, 49 percent of employees have at least some assets in a TDF when their plan offers one. Helping employees make the best use of their retirement plan investments—increasingly, through TDFs—can be critical to making sure they can retire when they—and their employer—want them to.

ABOUT THE SURVEY

This study was developed by Institutional Investor, in partnership with Prudential, to identify the investment risks and behavioral challenges that need to be addressed throughout the retirement planning process and how plan sponsors, advisers and consultants are trying to overcome them.

To support this research, a survey was distributed to Institutional Investor's audience of plan sponsors as well as advisers and consultants between January and February 2016. We received 511 completed survey responses from the plan sponsor audience and 295 completed survey responses from advisers and consultants.

Auto Enrollment: An automatic contribution arrangement that can be used as a feature in a retirement plan to allow employers to enroll employees in the company’s plan automatically upon meeting eligibility requirements.

Auto Escalation: A plan design option that allows a plan sponsor to increase participant deferrals annually by a set increment.

RISKS: Investing involves risk. Some investments are riskier than others. The investment return and principal value will fluctuate, and shares, when sold, may be worth more or less than the original cost, and it is possible to lose money. Past performance does not guarantee future results. Asset allocation and diversification do not assure a profit or protect against loss in declining markets.

The target date is the approximate date when investors plan to retire and may begin withdrawing their money. The asset allocation of the target date funds will become more conservative as the target date approaches by lessening the equity exposure and increasing the exposure in fixed income type investments. The principal value of an investment in a target date fund is not guaranteed at any time, including the target date. There is no guarantee that the fund will provide adequate retirement income. A target date fund should not be selected based solely on age or retirement date. Participants should carefully consider the investment objectives, risks, charges, and expenses of any fund before investing. Funds are not guaranteed investments, and the stated asset allocation may be subject to change. It is possible to lose money by investing in securities, including losses near and following retirement.

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