What happens next Where's my refund? Best CD rates this month Shop and save 🤑
MONEY
U.S. Department of Labor

Powell: Changes coming to target-date mutual funds

Robert Powell
Special to USA TODAY

The more things change in the world of employer-sponsored retirement plans, the less they remain the same.

And that's especially so when it comes to one of the most popular investment options in many 401(k) plans – the target-date mutual fund. Consider some of the findings from the 2015 Defined Contribution Trends report published last month by Callan Investments Institute, a pension consultant headquartered in San Francisco.

A couple meets with their financial adviser.

• About one in 10 plan sponsors replaced their target-date fund/balanced fund manager in 2014.

• The proportion of plans that offer their 401(k) record keeper's proprietary target-date fund declined from 47.5% in 2013 to 28.7% in 2014 and plan sponsors expect this number will decrease even further in 2015 (to 23.6%).

• And plans with custom target-date funds increased materially, from 11.5% in 2013 to 22.3% in 2014.

What gives? Why are plan sponsors dumping their record keeper's proprietary target-date funds and replacing them with custom target-date funds and, more important, what might you consider if you're investing or given the chance to invest in a custom target-date fund in your workplace retirement plan?

A target-date fund is a fund of funds which over time reduces the percent invested in stocks as the fund nears the date in the fund's name, a date that would typically correspond to the investor's planned retirement date. How funds reduce the percent invested in stocks vs. bonds is called the fund's glide path.

Personal finance advice columnist, Robert Powell

Among other things, a target date-fund is typically a default investment option for employees who are automatically enrolled in an employer-sponsored retirement plan such as a 401(k). A custom-target fund, unlike a publicly-traded target-date fund, is also built to suit the demographics of a particular company's workforce.

According to Lori Lucas, an executive vice president and defined contribution practice leader at Callan Associates in Chicago, there are several reasons why plan sponsors are starting to use custom target-date funds more and more.

Performance lagging. One has to do with performance. Lucas says record keeper's proprietary target-date funds have not performed all that well. "And that's caused some movement away from them," she says.

Plan sponsors have to document process. Plan sponsors are "beginning to rethink their target-date funds because they have become so sizable within their plans," Lucas says.

The average target-date fund, when it's available, represents 30% of an employer-sponsored retirement plan's assets. "As these funds get bigger and bigger, plan sponsors are taking a close look at them to make sure they fit in the plan," Lucas says.

And making sure such funds fit in the plan is an especially important task given the Labor Department's guidance issued in 2013. Plan sponsors must now document how they evaluate, select and monitor the performance of target-date funds offered to their 401(k) plan participants.

"The (Labor) department expects plan sponsors to fit the target-date fund to the demographics of the plan and document that process," Lucas says. Read Target Date Retirement Funds - Tips for ERISA Plan Fiduciaries.

"There's no hard and fast way to think about it," Lucas says. "But that process needs to be in place whereby the plan sponsor can document and justify why the glide path makes sense for their demographic."

For plan participants, there are several items to consider when investing in custom-target date funds.

Might not be a household name. These funds may not be offered by firms with household names. That's not necessarily a bad thing. It just means doesn't have "the brand cache," Lucas says.

No ticker symbols. And, these funds typically don't have ticker symbols and that makes it difficult to track such funds on investment web sites.

"But these are pretty ancillary things to consider when you're evaluating whether a target-date fund is going to be the best target-date fund for the plan," Lucas says. "Plan participants who have customized target-date funds should recognize the trade-off of not having a brand name or not having a ticker symbol is potentially much better performance or lower fees."

Keep a close eye on the investment committee. Plan participants who have custom target-date funds will also need to keep a close eye on their plan sponsor's investment committee, which is charged with overseeing the fund's performance and fees.

Many investment committees "take the position that the bar is even higher for target-date funds," which are often the default investment option in plans with automatic enrollment, says Lucas. "It's easy to determine whether the target-date fund manager is adding value or not through active management," says Lucas. "That's not that challenging. But what's difficult is to monitor the appropriateness of the glide path."

Plan participants should ask, for instance, their investment committee if the custom target-date fund is meeting the criteria established when the fund was selected for the 401(k) menu of investment options.

Benchmark performance. Plan participants should also benchmark the performance of their funds. Says Lucas: "Typically they are being benchmarked in a couple different ways; to their peers, or relative to a passively implemented index, or using retirement income adequacy analysis. Is the custom target-date fund's glide path geared to get people to a certain outcome in retirement?"

Monitor fees. Plan participants should also monitor the fees charged for custom target-date funds by checking the fund's expense ratio. Read Understanding Retirement Plan Fees and Expenses.

According to Lucas, services to operate a custom target-date fund are paid for through an arrangement known as revenue sharing. "Participants can expect to pay revenue sharing in target-date funds as well as other funds in the plan," she says. "It's still very common."

"'Revenue sharing' is the practice of padding a mutual fund's expense ratio with general plan administration, marketing and other non-investment related fees, leaving these expenses to be absorbed by participants who choose to invest in that fund," according to ERISA Fiduciary Administrators' website.

Lucas says participants should review overall expense ratio. "The revenue sharing will be embedded in that and if the overall expense ratio is high that's the concern," Lucas says.

TDFs are subject to market volatility. Misconceptions about target-date funds abound. "There's certainly no guarantees that the target-date fund will deliver any given level of return or that they will provide any specific amount of income in retirement," Lucas says. "That's not how they are built. They are subject to market volatility and many of them, depending on the glide path can have considerable market volatility or market exposure at retirement."

Understand the glide path. Investors also need to determine whether their target-date fund, custom or otherwise, has what's called a "to-retirement" or "through-retirement" glide path. The former could be less risky than the latter. "That's important for people to recognize," she says. "And if you're defaulted into a target-date fund that you're uncomfortable with you can always move to a less aggressive target-date fund or they can look at other options available in the plan as well."

Consider managed accounts. More and more plan sponsors are starting to offer alternatives to target-date funds that may appeal to older workers, whose financial situations can become much more complicated, such as managed accounts. "Those accounts can factor in more of the financial situation of the individual and it's less of a one-size-fits-all solution," Lucas says.

Robert Powell is editor of Retirement Weekly, contributes regularly to USA TODAY, The Wall Street Journal and MarketWatch and teaches at Boston University.

Featured Weekly Ad