How to select the right TDF for a 401(k) plan

Target-date funds are an attractive option for both plan advisers and participants.

The promise of TDFs is that they are designed to protect investor assets from the risk of large losses stemming from inadequate or improper portfolio diversification. For advisers, this is directly aligned with the obligation under the Employee Retirement Income Security Act of 1974 to protect assets. For participants, the funds simplify investment decisions.

But simply choosing any TDF won’t do, because there are underlying risks of choosing the “wrong” TDF relative to other available options.

In his book “Start With Why,” Simon Sinek makes the case that good decision-making is about answering the right questions in the proper sequence. The book stresses the importance of (1) understanding your purpose — your “why” — before you can reasonably determine (2) a strategy (“how”) to best achieve success and (3) a set of specific actions or tactics (“what”) required to execute a viable strategy. The why-how-what approach is designed to ensure that actions are purpose-driven, as opposed to the common tendency to make activity-driven decisions that prematurely focus on what can be done, before fully understanding what should be done.

The approach works well to frame a sound decision-making process for ERISA fiduciaries, including the process of selecting target-date funds.

To select the “right” TDF, the following represents a prudent process for fiduciaries to follow:

• Understand aspects of the participant profile of the plan (e.g., age, income, education and tenure distributions) that may influence participants’ investment needs and behaviors;
• Select a glide-path approach that is consistent with the participant profile;
• Consider whether a custom TDF may be feasible and offer advantages over off-the-shelf products;
• Perform thorough and objective due diligence on underlying investments to reasonably compare and rank available TDF alternatives;
• Consider how well the top-contending TDF alternatives align with other investment options in the plan, and any adjustments to the plan lineup that may be necessary or desirable;
• Implement decisions made as a result of the selection process; and
• Conduct regular monitoring to ensure that plan assets are adequately protected by regular “re-selection” or replacement of investment alternatives.

Each step in the process involves multiple considerations and could be the topic of a separate article. Given the importance of the glide path in choosing a TDF, the remainder of this article will focus on that issue.

Glide paths are frequently referred to as “to” or “through.” “To” generally means equity exposure (risk) is minimized at the expected date of retirement; “through” means equity exposure is comparatively high at the expected date of retirement but on a downward trend well past the expected time of retirement, potentially through the remainder of the participant’s life.

A “to” glide path seeks to minimize the risk of loss of capital in the years immediately preceding retirement (investment risk). The “through” approach seeks to minimize the risk of running out of assets before the end of life (longevity risk).

For most people (particularly healthy people with long life expectancies), longevity risk is a greater threat than investment risk. Longevity risk also rises with age because the longer one lives, the longer they are likely to live.

Few plans have a homogenous participant pool that would clearly dictate the selection of a specific glide path perfectly fitting all participants’ needs. It is also true that many plan participants, even those investing in “through” TDFs, liquidate their retirement plan assets upon retirement. For these reasons, it is generally not a good idea to only offer TDFs in a retirement plan. Having lifetime-income (annuity) and target-risk (flat glide path) options can provide important flexibility to meet the needs of participants who don’t fit the mold of a plan’s chosen TDF series.

Thoughtful and thorough application of the why-how-what approach to fiduciary decision-making is a great way to help ensure investors’ best interests are served and retirement advisers’ legal and ethical obligations are met.

Blaine F. Aikin is executive chairman of fi360 Inc.