Target date funds are an employee savings juggernaut and have become a key component of retirement plan advisors’ arsenals.
By automatically adjusting asset allocation from the higher risks of equity to the lower risks of fixed income as fund holders approach retirement, TDFs offer simplicity.
According to Investment Company Institute data, TDFs accounted for 15% of all 401(k) assets at the end of 2013, up from just 5% in 2006, when they were initially designated as a qualified default investment alternative for defined-benefit plans.
And within five years, TDFs might capture 90% of all new employee contributions, Cerulli estimates.
Many in the industry, however, caution that TDFs aren’t for everyone and that financial advisors and investors need to educate themselves about what assets are held in TDFs, especially for those approaching retirement.
As a default option, TDFs are a much better choice for younger savers than cash or stable-value products.
“The target date fund was meant to simplify [getting] a young worker into 401(k)s to get them out of cash,” says Craig Israelsen, principal at Target Date Analytics in Marina del Rey, Calif., which analyzes TDFs.
But the real impact will come when younger workers start saving 10% to 15% of their income each year, he says.
“At that contribution rate, they’ll have a fighting chance to be ready for retirement,” Israelsen says.
Once younger participants receive statements, they often start paying more attention. As their savings grow, they tend to move toward options that include personal financial planning.
Unlike younger workers, however, older employees closer to retirement likely need more specialized advice, advisors say.
“It becomes a potentially more risky vehicle as the individual approaches the latter years of their working career and into their retirement because it’s blind to their individual circumstances, which should factor into their retirement portfolio design,” Israelsen says.
In fact, at the end of 2013, 52% of plan participants in their 20s held TDFs, compared with 35% in their 60s, according to the Employee Benefit Research Institute.
Two years ago, the Securities and Exchange Commission’s Investor Advisory Committee issued recommendations to clarify TDF risks, fees and allocations and standardizing the presentation of glide paths.
In a February speech, SEC member Luis Aguilar said that reform is essential and that “it is imperative that investors better understand the risks presented by target date funds.”
Advisors often don’t ask enough questions about diversification and glide paths, says advisor Ron Surz, president of Target Date Solutions in San Clemente, Calif., adding that most TDFs have relied too heavily on chasing equity returns over the past six years.
“My strong suspicion is that they’re running north of 40% in equities at the target date,” says Surz, who runs a target date index fund.
“In 2008, that kind of risk lost people 30%,” he says. “People who were at or near retirement lost their shirts, and they had no idea that they had that exposure.”
Paul Hechinger is a New York-based freelance writer.
This story is part of a 30-day series on retirement planning strategies.