Editor-in-Chief, 401kTV
Fred’s Take: Unlike any investment available to workers in defined contribution (DC) plans, target date funds (TDFs) highlight the evolution of DC plans to become more like defined benefit (DB) plans. More DC plan sponsors are designing plans using auto features where, like DB plans, all decisions are made for workers including whether to join and how much should be deferred. TDFs signal the change to delegating investment decisions.
Though TDFs have been around for over two decades, their popularity grew with the 2006 Pension Protection Act in which Congress gave plan sponsors safe harbor to use balanced funds and TDFs as the default option especially important when plans employ automatic enrollment. According to a Fidelity Investment’s white paper, 85% of all DC plans use TDF as their default option. No wonder assets have swelled to almost $800 billion according to Morningstar, up from $116 billion in 2006.
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But unlike other DC investments, TDFs need to be evaluated based on the income they project to replace, not the last quarterly or even annual return. Used in conjunction with the Ideal Plan, TDFs can significantly boost income replacement ratios with managers looking at the liabilities rather than trying to beat benchmarks, just like DB plans.
And because all companies are not alike, they need to select the TDF fund right for their employees based on their behavior, like savings rate, income, retirement age, as well as their risk tolerance. No two glide paths, which indicate how much risk a TDF is taking as people get close to retirement, are alike with some assuming that investors will keep their money in the fund into retirement.
Understanding which TDF is right for a company is the most important investment decision a DC plan sponsor can make along with creating the right plan design. The Fidelity Investment white paper provides some insights which will be valuable when plan sponsors make these decisions.
