4 questions to improve your target date fund selection process

It's hard to argue that any mutual fund class has had a better run than target-date funds over the past decade.

Many investors are finding themselves consumers of these products due to the increase in companies automatically enrolling their employees into retirement plans. Assets in target date mutual funds have swelled to more than $850 billion.

With so much concentration of money in one type of investment, it's important retirement plan advisers have a process in place to choose the right target date fund for their clients. Here are a few questions advisers can use to improve their TDF selection process.

What percent of plan assets are attributed to terminated employees?

One area of easily recognizable difference among target date funds is a TDF suite's nature as "to" or "through."

A "to" fund's equity exposure will not become any more conservative once the fund hits the target date. "Through" funds will continue becoming more conservative after they hit the target date.

A 401(k) plan with a high percentage of assets attributed to terminated employees would indicate that many employees like the plan (but maybe not the employer) and will continue to leave their assets in it. If that's the case, a "through" strategy may be better suited to these employees.

The obvious benefit with this strategy is that as employees separate from the company and leave their assets in the plan, a "through" strategy would continue to reduce the equity allocation, as opposed to a "to" strategy, which would be stagnant and potentially leave separated employees with too high of an equity allocation.

What are the workforce demographics?

Workforce demographics are important when choosing the right target date fund for a plan.

For example, if a company's workforce is higher-income and likely to work longer, that would help justify a glidepath with a higher allocation to equities. Such a workforce has a longer time horizon in which to withstand the inevitable volatility that comes with owning equities.

If the demographics were opposite, that would justify a more conservative glidepath and equity allocation. The rationale here is that those with smaller balances and lower incomes cannot afford the risk associated with a high equity allocation closer to retirement.

An employer's industry type may affect such demographics. For example, a semi-conductor company is going to have wildly different demographics than a company in retail sales. The former is likely to have employees with high average incomes and long tenure, while the latter is likely to have the opposite.

Does the investment policy statement have language stating the asset classes a client wants to offer?

Ideally, a company should make sure any target date fund replicates the same asset classes included within their plan's investment policy statement, at a minimum.

A typical investment policy statement will indicate the asset classes a plan will contain and potentially exclude.

Many people would be surprised at how many TDFs don't provide what would be considered traditional asset classes, such as mid-cap and international fixed income. We view replicating this allocation as important, because it keeps an allocation consistent between what a participant may be able to put together with a plan's core funds and what they would get with the target date funds.

Does the company, or their employees, have a preference for passive or active managers?

The company's attitude toward fees and its belief in the value of active management play a part in the asset selection discussion. The same can be said on the discussion of asset location.

We often have conversations with clients in which they're fixated on TDFs with all passive investments, and have attempted to help them see the value of active managers, where it makes sense.

A blended approach of using an active manager to determine asset location and asset allocation, and splitting the asset selection between passive and active managers has been a nice option for plan sponsors interested in attempting to mitigate volatility for participants.

These products have also been able to meet the demands of employees that would like access to low-cost passive products. The trend toward passive TDFs is certainly not slowing down, and the fact that blended funds are popping up more and more is one example of how target date managers are attempting to yield to the market demand, while still attempting to provide value via the active space.

To sum up, the tide does not look to be letting up on the amount of money rolling into these funds. Plan sponsors need help to ensure they are exposing their employees to the appropriate fund. The questions above are a good place to start.

Aaron Pottichen is the retirement services president at CLS Partners, an Austin, Texas-based financial advisory firm focused on employer-sponsored retirement plans.

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