Plan Sponsor Series 3: Target This vs. Target That

Originally published October 5, 2018 by Lance Reising.

Target date funds and target risk funds are two common types of investments in 401(k) plans.  Both contain pro's and con's for participants and plan sponsors.  Topics discussed below include:

• Origin of the significance of these types of investments
• Behavioral aspects behind their popularity
• Contrast between the ease of use and complexity of their construction
• Pro's and con's of each type of investment
• Impact of each on fee structures and levels
• Impact of each on plan sponsor fiduciary liability

There are some significant trends occurring now in the defined contribution retirement plan industry, but perhaps none more significant than the explosive growth in target date funds in these plans. What is behind this growth and is it beneficial?

With the Pension Protection Act of 2006 came the provision for a Qualified Default Investment Alternative, a "QDIA". It allows a plan sponsor to have a 401(k) investor's funds to be automatically placed into a specified QDIA if that participant fails to choose a different investment. This happens with a lot of plan participants because trying to decide on a specific investment strategy and set of investments is daunting to many people. Our experience has been that many participants also choose to have their investment managed for them by professionals rather than doing it themselves.

For investors who do not want to make investment decisions and want professional managers to handle their money, fund providers have created two types of asset allocations funds where one can generally "set it and forget it", i.e. target RISK funds and target DATE funds. Both offer professional management, broad diversification, portfolio rebalancing, and serve as a QDIA for the plan. In a target DATE fund the QDIA is based on the participant's planned retirement age. In a target RISK fund, the QDIA is usually a Balanced Portfolio or a money market-type fund.

Both of these types of funds are highly beneficial for the majority of 401(k) participants. Which type of fund should you choose? It depends on whether you are a plan participant, a plan sponsor, or both, and what is important to you.

If you are a plan participant, target DATE funds are a low maintenance retirement product you can set on auto pilot, or set-it-and-forget-it, because they automatically adjust the asset allocations to become more conservative as investors approach retirement age. However, though they are an easy and peace-of-mind product, they are anything but simple in their construction and investing strategies. In fact they are quite complicated.

An investor (and especially a plan sponsor), should determine the "glide path" of the target DATE fund and determine whether it is a "to retirement" fund or a "through retirement" fund. What are the projected asset allocation change dates and to what asset classification percentages? Target RISK funds do not adjust the asset allocation mix over time, so it is up to the participant to change investments when one's risk threshold changes or as retirement nears.

Target DATE funds generally have higher total fees than target RISK funds because of this complexity and generally higher trading costs. Because target DATE funds are like a basket containing other funds, they may have an extra layer of fees from the underlying funds and some funds then add another fee on the target fund itself as an investment-choosing fee. Higher fees reduce returns, especially over a long period of time.

If you are a plan sponsor, target DATE funds' higher costs and greater complexity are significant factors to consider. This is because the greater the complexity of the investments, the greater the fiduciary liability risk for the plan sponsors. Plan sponsors are fiduciaries and as such are required to not only understand all these complexities and fees but to monitor them for adverse changes going forward.

This can also be true for target RISK funds if the underlying investments are actively traded investments which need constant and diligent monitoring. This is why we believe that if that the underlying investments are composed of low-cost index funds and ETF's representing what are effectively benchmarks themselves, then fiduciary liability and monitoring expense, administrative effort and time are greatly reduced.

Target DATE funds providers also usually install a whole family of funds from a single provider, or their own, that cover a range of 8 - 10 retirement dates. This raises the question whether all of their fund family members are the best choice for each retirement date or not. On the other hand, a target RISK funds group usually has from three to five different target risk levels ranging from conservative to aggressive. Again, less complexity and usually less inherent costs.

There generally is more underlying asset turnover in target DATE funds as well. The higher trading costs associated with them necessarily reduce returns. Relative turnover of assets should be examined and monitored both for target DATE funds and target RISK funds.

From a plan sponsor standpoint, target RISK funds are usually less complex and therefore, required monitoring and the accompanying fiduciary liability are less than for a target DATE fund. However, these two types of funds are not mutually exclusive. Many retirement plans offer both types of funds in their lineup.

The decision is up to the plan sponsor and the plan's financial advisor. The use of a 3(38) financial advisor who would choose and monitor the fund lineup can greatly reduce the personal and corporate fiduciary liability for the plan sponsor.

(Yes, we do that.)