By Amie Agamata
There’s no debate the average American doesn’t understand how the stock market works; financial literacy in our country is lacking. Even those who perceive themselves as financially savvy generally aren’t as knowledgeable as they think they are.
As a testament, many of the “investment gurus” in 401(k) plans we manage usually seek our validation their mutual fund selection is good. While advocacy for financial literacy education may help move the needle, applying behavioral finance techniques might be more effective to get individuals on track for retirement.
As financial planners, we know it can sometimes be difficult to encourage individuals to save money for their future especially those in low-income minority communities. Once individuals decide to take the right steps towards saving, we’re then tasked with the more complex topic: investment choices.
Regulations require us to disclose and share many details around risk, expense ratios, turnover rates, and so much more. Education around choices is important for individuals to make decisions in their best interest, however, too much information may lead to delay of execution or worse, no action taken whatsoever.
Many investors prefer to have financial professionals make these choices for them rather than spending countless hours educating themselves to be able to make the right decision. This is especially true for many 401(k) participants, which is why Target Date Funds (TDFs) came into existence.
The first Target Date Fund (TDF) was created in 1994 by Wells Fargo and Barclays Global Investors. “Their [investment] strategy was to get the investor safely to the target date and at that point to fold the dated fund into their Income fund,” one comment reads.
Since then, TDFs have become the most popular Qualified Default Investment Alternative (QDIA) in 401(k) plans. A QDIA is the default investment option for employees who contribute to the plan yet don’t indicate how they want their money to be invested.
Here are 3 Questions to Consider When Selecting Target Date Funds:
1) What’s the investment approach? All investments are created with different approaches based on the specific fund manager’s investment philosophy and strategy. TDFs are no exception, however, they tend to follow one of two investment approaches – “to” versus “through.” You can think of it as the fund will be managed to either help the participant get “to” retirement or “through” retirement.
Typically, stock allocations are reduced to the lowest percentage at the target date in “to” funds meanwhile the stock allocation continues to decrease through the target date and into retirement in “through” funds. It’s important to understand the differences between these strategies and know which one your client is invested in through their 401(k) plan. If you manage 401(k) plans, then you will want to review which Target Date Funds are available in the plan’s lineup.
2) What’s the actual allocation? Almost every fund family whether its American Funds, Vanguard, Principal, etc. offers its own set of Target Date Funds these days. The options are seemingly endless. More choices for plan sponsors to choose from leads to more competition between the fund managers to outperform the others. The same was true in 2008. Back then, many managers achieved higher returns by allocating more towards equities, including 2010 funds.
One would think 2010 TDFs would be invested more conservatively in 2008 since the target date was only two years away. However, most of the 2010 TDFs experienced significant losses in 2008. The losses were unacceptably comparable to aggressive portfolios.
Fast forward to today, we would expect fund managers to have learned the regretful lessons from 2008 and assume 2025 TDFs are invested in balanced to conservative allocations. Out of curiosity, I conducted research on all existing 2025 TDFs and discovered there is no standardization across the 53 options. If you look at the asset allocation on the fact sheet, it may appear the 2025 TDFs are conservative. However, junk bonds must not be forgotten. These types of bonds behave like stocks.
That means if 50% of the fixed income portion is invested in junk bonds, then the allocation is much more aggressive than presented. When junk bonds are taken into consideration, there are a surprising amount of 2025 TDFs with an aggressive allocation (70%+ in equities comparable risk). I also found many of the 2030 TDFs to have more risk than I would expect someone less than 10 years away from retirement to be comfortable with.
As advisors, we must recognize that while TDFs are good in theory, one should be considerate of how the different options match the risk profiles of the company’s participants. One high risk set of target date funds may not be in the best interest of participants at one company yet may be in the best interest of the participants at another company.
In short, due diligence helps ensure the target date series is in the best interest of our clients. Best practice is to have your client complete a risk tolerance questionnaire then compare their comfort level to the risk taken in the appropriate TDF. If it’s not in alignment with their objectives, then consider other recommendations that are.
3) Is there a better solution? TDFs are nice in concept. They’re easy for plan sponsors and, more importantly, participants to understand. However, if the fund isn’t managed according to how it’s supposedly designed i.e., it doesn’t automatically adjust and reduce risk as the participant gets closer to the target date then it may not be the best option.
There are few recordkeepers who provide better solutions, such as a managed account. According to a Morningstar study by David Blanchett, PhD, CFA, CFP®, “managed accounts resulted in portfolio risk levels that were more appropriate for investors, based on Morningstar’s portfolio assignment methodology.”
A Managed Account Solution
While a few recordkeepers offer a managed account solution, Unified Trust, which is a subsidiary of American Trust, offers a managed account solution called the UnifiedPlan for all participants at a relatively minor additional cost. The plan sponsor has the option to absorb the costs or pass through to the participants.
The UnifiedPlan’s strategic advantage in the marketplace is the customization to each participant based on several factors including age, income, savings rate, and assumptions around retirement age, social security income, etc.
Essentially, the UnifiedPlan manages the account with the least amount of risk to get the participant on track for retirement. That means someone in their 20s who would typically fall under an aggressive TDF may be invested balanced to conservatively if they are already on track for their goals.
Additionally, as part of the managed account solution, a significant portion of the bond allocation is made to a stable value fund. Participants have the option to invest in something more aggressive or conservative if they feel the managed account solution is not in alignment with their risk tolerance.
Don’t get me wrong, I like Target Date Funds. The “set it and forget it” strategy is effective at getting participants invested in the stock market rather than sitting in a money market fund. Plus, there’s generally low minimum investments and the funds are professionally managed by the portfolio manager.
My concern is “one size fits all” approaches are often flawed. Think swimsuits, jeans, any clothing… While good in theory, everyone is unique whether it’s body shapes or risk tolerances. Something in the best interest of one person doesn’t necessarily mean it’s right for another.
Amie Agamata is a CERTIFIED FINANCIAL PLANNER™ in San Diego, CA with clients across the U.S. Her team’s business mission is “Working together to achieve financial success through understanding, education, and action©.” Amie is the NexGen President-Elect for the Financial Planning Association (FPA) nationally, member of the FPA Retirement Income Planning Advisory Council, and serves on The American College Alumni Council.
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