Looking ahead, Vanguard researchers estimate that 77 percent of the participants on the firm’s recordkeeping platform will be invested in a single target-date fund (TDF) by 2022.1 Furthermore, nearly 90 percent of all new 401(k) plan contributions will be in TDFs by 2020.2 As a result, it is imperative that 401(k) plan fiduciaries have a proper process in place. By leveraging the following best practices, plan sponsors can apply the Department of Labor’s tips to properly manage the TDFs on their platform and strive to fulfill their fiduciary duties.
Many people lack the will, skill, or time to properly manage the investments in their retirement plan accounts. Target date funds provide a simple way to have access to a portfolio that diversifies asset allocation and is periodically rebalanced to reach a progressively conservative asset mix as the participant approaches retirement. This simple explanation, however, does not go far enough in explaining the many differences that target date funds have. In other words, not all target date funds are created equal, which is why further guidance is needed to ensure the obligations of plan fiduciaries can be properly met in respect to these investments.
As previously mentioned, TDFs have increased in popularity and are expected to continue to do so. With the markets at the time of this writing being close to (or at) new all-time highs, now is a great time to revisit this important topic, which last became a subject of scrutiny during the 2008 financial crisis.
To provide you with some background, a DOL fact sheet3 published in February 2013 contained the following tips to help plan sponsors aim to meet their obligations:
- Establish a process for comparing and selecting TDFs.
- Establish a method for the periodic review of selected TDFs.
- Understand the fund’s investments – the allocation in different asset classes (stocks, bonds, and cash), individual investments, and how these will change over time.
- Review TDF fees and investment expenses.
- Inquire about whether a custom or non-proprietary TDF would be a better fit for your plan.
- Develop effective employee communications.
- Take advantage of available sources of information to evaluate the TDF and recommendations you received regarding the TDF selection.
- Document the process.
Using the following five-step process, we help our clients implement the DOL recommendations so they can strive to properly manage the target date funds offered in their retirement plans, and uphold their fiduciary obligations.
1. Develop a process for TDF selection and validation.
- Identify the goals of including target date funds in the plan; verify sponsor objectives and workforce needs.
- Determine if the TDFs are aligned with the plan’s demographics and investment policy statement.
Forrest Ross, LMC Financial Advisors retirement services director explains, “Plan sponsors need to be aware of the glide path that TDFs follow. They are typically structured to take participants ‘to’ retirement or ‘through’ retirement. When it comes to making appropriate selections for your plan, it’s critical to understand this distinction.”
In addition to the most appropriate glide paths, participant age range, anticipated retirement dates, and potential withdrawal patterns all play a part in selecting target date funds with appropriate target dates. For example, some participants may intend to begin withdrawing assets immediately following retirement. An appropriate glide path for them might be one in which the asset mix gets most conservative at retirement. Alternatively, other participants may not intend to make withdrawals for many years after retirement. An appropriate glide path for them might be one in which the asset mix gets progressively more conservative through retirement.
Plan sponsors should also consider other important criteria about TDFs. For example, is a non-proprietary or proprietary fund a better fit? Is the fund a Qualified Default Investment Alternative?
It's important to note that TDFs are known as “funds of funds,” which means the manager of the target date funds uses other mutual funds to invest participants’ funds instead of selecting individual securities. This can increase the total cost of the TDF models considerably. Also, many target date funds are proprietary, meaning that the fund managing the target date funds uses their own proprietary funds to invest in other asset classes.
Ross states that “The chances that all of the proprietary funds in the model are the best in each fund category are low, which means plan fiduciaries should be prepared to add another level of scrutiny in evaluating the funds that make up the investments of the target date fund.”
Ross adds, “I am seeing more plans offer the ability to implement TDF models using the core mutual fund line up of the plan. This has made the evaluation of the target date funds easier, as the core line up is constantly reviewed and amended when necessary, which directly feed into the target date fund models. Another thing to be aware of is the all or none option that some investment providers are giving plan participants. Some providers require that participants either be fully invested in the target date funds or not at all. Plan fiduciaries want to make sure that this is something their participants are comfortable with before making the decision.”
2. Establish and undertake a periodic review process. Things change over time, and the items that tend to have the most impact include fund management changes, a change in the fund’s investment mandate, a change to your plan's investment selection criteria or investment policy statement, fund performance, or a change in participant demographics. Having a process in place to monitor these changes and initiate a review of the plan's TDFs will allow you to stay on top of the plan's offering and ensure they continue to be in the plan's best interest.
Here is what we recommend:
- Consider if the TDF is meeting plan goals and expectations.
- Determine if there have been any changes of significance to the plan or TDF.
- Consider whether the adoption of one-time or automatic re-enrollment into the TDF may help improve the asset allocations of plan participants or boost overall participation.
- Review the TDF’s performance, glide path, and underlying investments to maintain alignment with plan objectives.
3. Examine expenses and fees. Benchmark the TDFs against similar funds on a quarterly basis.
4. Establish and review participant communications and required disclosures. Participants must be provided with timely and accurate information around the basics of target date funds. Also, detailed information about the specific target date funds in the plan, along with the relevant fees and expenses should be communicated. Unless plan sponsors have the level of expertise required to perform these duties, they should consider leveraging the expertise of seasoned professionals.
5. Document results of the review and amend plan documents. This step is critical for plan fiduciaries. You must document the process that demonstrates the selection and review process and how your final decision was made, in addition to updating the plan’s investment policy statement if necessary.
With the popularity of target funds growing, there is increasing scrutiny from regulators on the process used in the selection of funds. It is critical that plan sponsors use a well-defined process that both drives better outcomes for stakeholders and satisfies their fiduciary obligation. We hope that in writing this piece we have given you something to think about, and have helped you get well on your way to creating a process that works for you.
If you have any questions or would like to discuss this topic further, please contact a member of our team. We are here to help.
Securities offered through LPL Financial, Member FINRA and SIPC. Investment Advisory Services offered through LMC Financial Services, a registered investment advisor. LMC Financial Services and LPL Financial are separate non-affiliated entities. LMC Financial Services and LPL Financial are not affiliated with Vanguard.
This information is not intended as authoritative guidance or tax or legal advice. You should consult with your attorney or tax advisor for guidance on your specific situation. In no way does advisor assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations.
All investing involves risk including loss of principal. No strategy assures success or protects against loss.
An investment in a target date fund is not guaranteed at any time, including on or after the target date, the approximate date when an investor in the fund would retire and leave the workforce. Target date funds gradually shift their emphasis from more aggressive investments to more conservative ones based on the target date.