Investment Insight

If you advise 401ks, you’re probably well aware of the surging use of Target Date Funds (TDFs). The Department of Labor gave them a major boost when it ruled that they were a safe harbor QDIA if all that was considered when assigning them was age — nothing else. TDFs are perfectly suited for this because they’re designed to be selected by retirement age. For participants who are fifty years old, assign them a 2025 fund. Those who are a little younger, say 30, get a 2045 fund, etc. It doesn’t matter how much the participant has already saved or if he’s very risk averse, as long as the TDF roughly aligns with his retirement age, you’re in the clear.

But all TDFs are not created equally. Some carry aggressive amounts of equity not only during the working years but into retirement. Some are more conservative over the entire period. Most 401ks only draw from one family of TDFs, so if they’re aggressive, everyone gets aggressive investments. If they’re conservative, everyone in the plan is conservative. Truth be told, because the plan will rely on only one family, you as the adviser, have more of an impact on the participants’ retirement success than they do.

Because of this, you need to be a little more diligent in selection of TDFs. The distinguishing feature is the so-called “glide path”, the gradual equity (risk) decline as the participant ages, so this should be your focus.

An effective approach begins with the creation of an efficient frontier using the asset classes of the TDFs being considered. Use forward-looking assumptions for risk, return, and correlation, not just historical results. We’d recommend the Black-Litterman methodology, but Ibbotson’s building-blocks, or even estimations of the values could work. Once you’ve established your frontier, see how your universe of potential TDFs align along it. The family that most closely adheres is your best alternative.