Wealth & Risk Management Blog

William Byrnes (Texas A&M) tax & compliance articles

Target Date Funds on Top of the Defined Contribution World

Posted by William Byrnes on April 8, 2011


Why is this Topic Important to Wealth Managers? This topic discusses a relatively new form of retirement investment offered by companies to their employees. The topic presents information about target date funds, what they are, who may use them and how they work. The defined contribution retirement market is a prime location for wealth managers to earn fees and commissions. Thus, staying informed about new market updates is provided to give managers an edge when exploring retirement benefits.

The Government Accountability Office recently published a report stating that financial security of millions of Americans in their retirement years will substantially depend on their savings in 401(k) and other defined contribution (DC) plans. [1]The GAO notes, to help ensure adequate financial resources for retirement, participants in DC plans should make adequate contributions during their working years and invest contributions in a way that will facilitate adequate investment returns over time.

To that end, the Pension Protection Act of 2006 (PPA) included various provisions designed to encourage greater retirement savings among workers eligible to participate in 401(k) plans, such as provisions that facilitate plan sponsors’ adoption of automatic enrollment policies. [2]

Under such policies, eligible workers are automatically enrolled unless they explicitly decide to opt out of participation. Because an automatic enrollment program must also include a default investment—a vehicle in which contributions will be invested absent a specific choice by the plan participant—the act also directed the Department of Labor to assist employers in selecting default investments that best serve the retirement needs of workers who do not direct their own investments. Since that time, target date funds (TDF)—that is, investment funds that invest in a mix of assets, and shift from higher-risk to lower-risk investments as a participant approaches their “target” retirement date—have emerged as by far the most popular default investment.

TDFs are designed to provide an age appropriate asset allocation for plan participants over time.    However, target date funds vary considerably in asset structures and in other ways, largely as a result of the different objectives and investment philosophies of fund managers. In the years approaching the retirement date, for example, some TDFs have a relatively low equity allocation—35 percent or less—so that plan participants will be insulated from excessive losses near retirement. Other TDFs have an equity allocation of 60 percent or more in the belief that relatively high equity returns will help ensure that retirees do not deplete savings in old age.

TDFs also vary considerably in other respects, such as in the use of alternative assets and complex investment techniques. In addition, allocations are based in part on assumptions about plan participant actions—such as contribution rates and how plan participants will manage 401(k) assets upon retirement—which may differ from the actions of many participants. These investment differences and differences between assumed and actual participant behavior may have significant implications for the retirement security of plan participants invested in TDFs.

Read the analysis at AdvisorFYI

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