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Keep Clients From Falling Into Target-Date Traps

October 17, 2013

Target date funds (TDFs) are a big deal, the biggest deal in 401(k) land. Propelled by the Pension Protection Act of 2006, which broadly reformed the rules governing both defined-benefit and defined-contribution plans, assets in TDFs have grown more than sixfold since the end of 2005, from $71 billion then to $500 billion in this year’s first quarter, according to Morningstar. By 2020, Casey Quirk & Associates has predicted, assets under management in TDFs will hit $3.7 trillion. At that point the funds will account for 48% of the entire defined-contribution market.

Because TDFs have become such a big deal, fiduciaries should be particularly conscientious about choosing them. Near-dated funds suffered substantial losses in the last market crash, and the next downturn could have ugly repercussions. A major correction is likely to prompt lawsuits; investors in near-dated TDFs that get hammered will want to know why their advisors didn’t learn a lesson from 2008.

To keep clients on track financially — and keep yourself from potential legal trouble — here are some tips for navigating this enormous market:

  • Many fiduciaries don’t vet their TDF selection, even though they should. Roughly 75% of TDF assets are with the Big Three: Vanguard, T. Rowe Price or Fidelity. “Safety in numbers” isn’t prudent when it comes to investing for retirement. Fiduciaries are held to the duty of care, which means they must try to select the best funds, rather than what is convenient and familiar.
  • Just because a product has QDIA (qualified default investment alternative) status doesn’t mean it’s the best choice for your clients. You need to base your selection on what works for them and their individual objectives. Throwing a dart at the QDIA dartboard is imprudent.
  • Don’t try to make money for clients with TDFs. Capital preservation should be fiduciaries’ primary goal in these funds. Safety is what participants believe they are getting when they invest in TDF funds.
  • Many TDF managers failed to adjust their funds’ risk exposure at the target date after the last financial crisis, so investors remain vulnerable as they approach retirement. Look for highly diversified TDFs with risk controls that guard against losses as the target date nears. Indeed, the most important distinction between TDFs is their risk exposure (in stocks and bonds alike) at the target date. There is a wide dispersion of risk at the target date across TDFs, whereas the funds all look very similar at long dates. And risk near the target date is critical to clients’ standard of living in retirement.
  • A TDF manager should provide comprehensive, reliable service for a fee of less than 40 basis points.