As target date funds (TDFs) become more popular especially in defined contribution plans like 401(k)s, understanding how they work can make a big difference on their effectiveness. 88% of companies sponsoring a DC plan record kept by Vanguard, the leading TDF provider, offer a TDF and 64% of the participants use them. So do users understand what they are investing in?
First let’s understand the drivers behind the phenomenal growth of TDFs. Before the 2006 Pension Protection Act (PPA), plans using auto-enrollment were concerned about liability if automatically enrolled participants lost money in the default option. So many defaults were Money Market funds with very low risk and equally low yields. The PPA gave plan sponsors safe harbor to use balanced funds like TDFs as their default of QDIA (qualified default investment alternative). TDFs are now approaching $800 billion.
So do participants understand TDFs? Mostly, yes:
- 64% understand that the asset mix or glide path changes over time getting more conservative as investors get closer to retirement.
- 57% realize that TDFs include diverse investments such as stocks and bonds.
- 50% know that these investments are professionally invested designed to be an all in one solution.
But:
- 19% think that TDFs provide guaranteed income.
- 14% believe that TDFs rate of return is guaranteed.
If only 50% of TDF investors know that these investments are an all in one solution, at least 50% and likely more are not using them properly including other investments to augment the glide path and diversification of a professionally managed portfolio. Seriously?
Plan sponsors need to pay extra attention to the selection of their TDF not picking them just because it’s offered by their record keeper. As an all in one solution, the selection applies to ALL employees, unlike individual investments which can be used by employees to create their own portfolio. In turn, employees need education not on how to invest or what each asset class means but how to properly use TDFs which comes from an understanding of what they are supposed to accomplish.
