Target date funds (TDFs) are typically mutual funds and can include a mix of stocks, bonds, and other investments. This investment option is designed to be long-term strategy for individuals planning to retire at a particular time. TDFs are an increasingly popular way to invest for the following reasons:
- Ease of Use: TDFs typically range in five-year increments, and the level of investment risk shifts based on the projected time of retirement. For instance, a 35-year old participant who wants to retire in 30 years at 65 years old could select a 2050 TDF (2019 + 30 years = 2049). A money manager would invest all of the assets of the fund at a risk level that is considered appropriate for a 35-year-old, and gradually shift investments to more stable investment assets as the fund approaches its target date.
- Compliance: To be in compliance with section 404c, all 401(k)s must offer a Qualified Default Investment Alternative (QDIA). This means that if a participant enrolls in a 401(k), but did proactively select an investment, the plan can automatically direct the savings into an QDIA and will not be liable for potential losses. The Department of Labor estimates that 97.6% of retirement plans featured a TDF as a QDIA.
Industry wide, TDFs now represent over 20% of all 401(k) assets. Among the 401(k) accounts that I advise, TDFs make up 40-50% if the accounts. While TDFs are growing popularity, it is essential to understand how to include target date funds in your investment line-up because there are major differences between TDF providers, in terms of risk, fee structure and performance.
Major Differences between Target Date Offerings
Risk: TDFs within the same date category can have very different risk profiles. The glide path charted below represents the percentage of assets allocated to stocks and bonds, a proxy for investment risk/return. In this example, this portfolio manager has 90% of assets allocated to stock investments 30 years before retirement. That percentage falls to 60% on the target date and continues to fall until 25 years after the target date. The concept here is that after someone retires, their money will still need to earn a healthy return during retirement so that it does not get depleted too fast.
Source: Department of Labor
However, another TDF may have a completely different risk profile and still call itself a “2050 TDF.” The glide path charted below is for another 30-year TDF, but in this one the provider allocated approximately 75% of a participants’ portfolio to stocks and 25% to bonds. Over time, the portfolio managers changed the portfolio’s composition of stock investments to be much more stable: Approximately 25% stocks/65% bonds/10% cash on the target date. This is a significantly lower investment risk profile and an investor could expect this fund to have lower volatility and returns (over time).
Source: Department of Labor
Fees: Almost every TDF fund has multiple share classes for the exact same fund. For instance, John Hancock has over 9 different share classes for its “John Hancock 2045 Fund”, with annual fees widely ranging from 0.58% – 1.34%. Several of these funds have an additional 12b-1 fee of 0.05% – 0.50%. Certain fees could pay for other expenses (such as administration or record keeping), but 401(k) plan sponsors need to keep their eyes open wide on this issue, as I often see plans that are unnecessarily paying fees that are 50% higher than a competitive alternative.
Performance: Comparing the lowest fee share class 2045 TDFs against each other for relative performance yields some interesting results. There are 21 funds in this comparison pool representing $76 billion in assets. Surprisingly, the low fee funds (primarily index funds) underperformed the average as a group in every period except for one. The Mid-Range Fee TDFs did the best by outperforming the averages in every time period. However, within these groups are funds that have consistently outperformed their benchmarks and peers for every single period. In some cases, this outperformance is extremely significant – over 1.0% annually for the 3-year, 5-year and 10-year time frames.
Source: fi 360, Sapling Wealth Management
Where Does Your 401(k) Stack Up?
This analysis shows that there are meaningful differences in the types of strategies a plan sponsor can pursue when crafting your investment line-up. I believe that TDFs should be at the core of this strategy. However, there are huge differences between fund families, in terms of glide path profiles, fees, and performance.
Where does your plan stack up? If you would like me to look into how your line-up is performing, I can let you know how you are doing in under 24-hours. Let’s chat!