According to Morningstar, target-date funds (TDFs) attracted approximately $70 billion in 2015. Another research firm, Cerulli Associates, has predicted that 88% of new 401(k) contributions will go into TDFs by the end of 2019. As this market expands, new versions are appearing: the “custom” TDF has been labeled the fastest growing segment.
The rise of custom TDFs is somewhat ironic, as these funds are meant to be one-size-fits-all for investors. TDFs are on the short list of qualified default investment alternatives (QDIAs). Department of Labor (DOL) regulations allow retirement plan sponsors to put contributions by plan participants who do not specify investment choices into a QDIA without being responsible for investment losses. That’s a prime reason for the growth of TDFs.
Now that custom TDFs are emerging, they help to point out that “regular” TDFs have cons as well as pros. If you invest in a TDF or if you’re considering one, you should know what’s inside the package, so you can decide on an appropriate strategy, going forward.
As the name suggests, each TDF has a target date: 2030, 2035, 2040, etc. These dates are meant to indicate the year closest to a participant’s anticipated retirement date.
Example: Lynn Martin, age 40, begins a new job at a company with a 401(k) plan that includes a series of TDFs. She plans to retire at age 65, so she chooses the TDF dated 2040, when Lynn will be 64.
A TDF typically will be a fund of funds. Thus, Lynn’s chosen TDF includes a variety of stock and bond funds, currently allocated in a manner that the fund company believes is suitable for someone 24 years from retirement.
In this hypothetical example, Lynn’s TDF now has 60% invested in equity funds and 40% in fixed-income funds. TDF funds have a “glide-path,” decreasing the exposure to stocks as the target date nears. Lynn’s TDF may have 40% in equities and 60% in fixed income by 2040, providing less market volatility and more income for shareholders who are in or near retirement.
TDFs don’t cease to exist at the target date. Instead, they continue on, providing shareholders with the option of cashing in for retirement expenses of staying invested, just as would be the case with any mutual fund. Some TDFs reach their most conservative asset allocation at the target date and remain there in future years. Many other TDFs, though, continue on their glide paths by reducing equity exposure for another 5, 10, 15 years and sometimes even longer.
Just as not all TDFs are alike, the same is true for participating employee groups. “Vocation and location” can make a difference, Morningstar has asserted, when designating custom TDFs. A relatively young group of technology employees in Silicon Valley, for example, may have a different approach to retirement planning than workers at an industrial plant in the Midwest. A company in the oil industry might better serve plan participants with a series of TDFs with less exposure to investments correlated with oil prices and energy stocks because employee job security in that industry is highly vulnerable to those trends.
TDFs can be customized in numerous ways, from tailoring the glide path to cherry picking underlying funds to including asset classes not typically found in standard TDFs. The constant, at least so far, is the expense involved in creating and administering custom TDFs. For now, custom TDFs are generally offered by companies with retirement plans holding at least $100 million of assets. As the concept evolves, custom TDFs may become available to smaller companies or even to specific employee groups within large firms.
No matter what type of TDF you might consider, look closely to see just how your money will be invested. Moreover, you should keep in mind that you can put together your own custom “target-date portfolio” if you’re willing to devote the time and effort to researching your own investments. Alternatively, you can seek a financial adviser with a proven record of developing individualized asset allocation strategies for clients as they head toward and through retirement.