Target date funds have become popular with 401(k) plans (defined contribution) because of their simplicity. Based on the participant’s age a projected retirement date is determined, for example a 37 year old will retire at 65 in 2040. Therefore this participant would choose the 2040 portfolio and as the participant ages the portfolio would automatically become more conservative. Problems arose during the ‘Great Recession’ participants in the 2010 portfolios thought they were very conservative and lost 38%. Hardly the conservative choice participants expected. It turns out all target date funds are not created equal.
An alternative has been gaining momentum. Professionally managed risk adjusted globally diversified portfolios. These portfolios have a defined expected return and expected volatility (risk), there will be no surprises. These portfolios, like target date funds, provide a pension fund like investment without the uncertain level of risk. Managed portfolios provide a level of clarity and defined risk and volatility.
The Pension Protection Act of 2006 allows plan sponsors to utilize the Qualified Default Investment Alternative QDIA. This Act allows the participant to be automatically put into the appropriate portfolio based on their age. The participant is moved automatically, to a more conservative portfolio as the participant ages.
In this plan design the participant has three options:
- Remain in the default portfolio
- After an assessment determine the proper level of risk and adjust the portfolio either more conservative or more aggressive.
- Opt out of the model portfolios and choose their own fund mix.
Combine this design with the plan sponsor hiring an ERISA 3(38) Investment Manager and the plan sponsor will realize minimized fiduciary risk and a quality retirement plan for their employees.
A number of studies have determined that most plan participants prefer the model portfolios (QDIA) to choosing their own fund mix. After experiencing the extensive volatility participants are looking for guidance from their employers.
- Target Funds End Year Far From Bull’s Eye (smartmoney.com)
- Target-Date Funds: Another Bad Year? (money.usnews.com)
- The Big Flaw in 401(k) Reform (401kplanadvisors.com)