Careful attention needed when choosing target-date funds

The U.S. Department of Labor's Employee Benefits Security Administration guidance on selecting and monitoring target-date funds in 401(k) and similar participant-directed individual account plans recommends plan executives consider a “custom or non-proprietary” target-date fund as a potential solution.

Target-date funds can be a good fit for retirement plans. They are easy for participants, allow for automatic investment and rebalancing and — when used properly — are generally blunt instruments designed to help uninvolved investors achieve reasonable asset allocations. In fact, target-date funds are in 68.6% of retirement plans and have attracted 12.4% of plan assets, according to a 2012 PSCA survey. But pre-packaged target-date funds might have considerable drawbacks — especially in an era of increasing regulatory scrutiny.

Many industry experts have warned for some time about the fiduciary concerns with using pre-packaged target-date funds absent a comprehensive selection process. General complexity and lack of uniformity can make these funds difficult to understand, monitor, compare to each other or even compare to a benchmark. Given these difficulties, ensuring — and documenting — that proprietary target-date funds comply with a plan's investment policy statement may be nearly impossible.

Using a custom target-date solution would help address those challenges — and others. In fact, according to a recent survey, more than half of consultants, 51%, believe a custom target-date approach is an improvement over current packaged funds, according to a 2013 PIMCO survey.

By choosing a custom target-date solution, a plan sponsor can avoid being locked in to one manager for all underlying components of the target-date funds.

What's more, a custom approach allows plan executives to leverage their core lineup — presumably composed of “best in breed” funds. In a well-managed plan, these funds are already subject to rigorous fiduciary oversight and control — and those same monitoring efforts will be automatically applied to the target-date solutions.

Plan executives readily admit they are not confident that the funds underlying their target-date funds are best-in-class. Specifically, although more than 80% of executives believe they have a fiduciary duty to evaluate underlying investments in target-date funds, the majority, 57%, of those whose plans use a single-manager target-date fund are unsure about having best-in-class underlying funds, according to 2013 information from Janus Group.

Fiduciary liability concerns can arise from this uncertainty. For example, a plan sponsor might choose to replace a core fund in the overall investment lineup — but that fund might still be a component of a pre-packaged target-date fund. With a custom solution, the unwanted fund would automatically be removed from the target-date solution as well — ensuring a consistent investment monitoring process for all funds.

There is some debate about whether an off-the-shelf target-date fund approach or a custom target-date solution increases fiduciary exposure. The former could increase the risk of fiduciary exposure in the absence of a prudent, thoughtful and well-documented process. Conversely, a custom approach would require greater plan sponsor involvement with more and different decisions to be made. Whichever approach they use, plan executives must pay careful attention to the decision-making process, consult experts as appropriate and document the basis for decisions.

Although custom target-date funds were first used by billion-dollar plans — and then moved down market to $500 million plans, custom target-date funds are no longer just for large plans. In fact, one-quarter of all plans are considering or already have customized target-date funds in place. And more small- and midsize plans are considering them than in the past two years, according to 2013 Janus data. This is largely driven by technology-enabled solutions that allow plans of virtually all sizes to take advantage of an open architecture approach. And some of these allow for a risk overlay for participants who desire a more conservative or more aggressive approach.

Many retirement professionals believe pre-packaged target-date funds, particularly those proprietary to a plan's record keeper, could eventually face increased regulatory scrutiny. The recent EBSA guidance might therefore be just the first step. n