Recently, it has become popular for large corporations to adopt customized target date fund approaches for their 401k plans. Before jumping into why this approach has never made much sense to me, it might be good to start out with a couple definitions.
Why Custom TDFs Are Bad
What are TDFs (Target Date Funds)?
Many mutual fund families have created an integrated series of investment funds with dates in their names. The dates approximate the time period that a participant will turn age 65 and retire. These professionally managed investment funds vary their bond/stock allocation percentages as time goes by so that as a participant gets closer to age 65 his/her allocation becomes more conservative. Target date funds are generally considered to be the most appropriate investment for the vast majority of your 401k plan participants.
What are custom TDFs?
Custom TDFs use a unique set of underlying investments and/or alter the bond/stock percentages significantly for the different funds in the series. These different bond/stock allocations are based upon demographic assumptions unique to the client. The intent is to create a non-standard glide path for the target date series.
Why I don’t like custom TDFs
I have never understood why plan sponsors find custom TDFs appealing since they may:
- Result in much higher costs. Although a selling point of custom TDFs is often the ability to lower overall fees, that isn’t always the outcome. Use of a customized series may, in fact, result in much higher advisor fees due to the time and effort required to construct the customized series and the extra research required to produce quarterly performance reports.
- Use inappropriate investments. As demonstrated in a recent lawsuit against Intel, where private equity and hedge fund investments were used to construct a custom target date series, a plan sponsor may find that the underlying investments an advisor recommended are not appropriate. The types of investments used in the Intel plan appear to be very high cost for plan participants and very lucrative for the advisors.
- End up white labeled. A customized target date series essentially becomes a white labeled set of funds with all the negative attributes that result from white labeling. The funds are no longer transparent to participants, cannot be reliably benchmarked and are not easily understood by plan participants.
- Be constructed based on questionable assumptions. The notion that future non-standard retirement activity can be modeled accurately is nonsense. A frequent reason cited to adopt a customized approach to target date funds is because of demographic differences in an employee population that are expected to result in retirement patterns that are non-standard (e.g.; a lot of retirements sooner or later than age 65). It seems nearly impossible to me to be able to predict the retirement patterns for a specific demographic group 30 or 40 years from now with any degree of accuracy. As a result, how can any advisor say that a certain set of bond/stock splits are more appropriate than what is being used in a standard set of target date funds?
- Be less transparent. Although greater transparency is an argument used for constructing custom TDFs, it is likely that most participants will have far less of an understanding of the investment managers selected in a customized series. Most standard target date series use mutual funds as the underlying investments. Data is publicly available for nearly all mutual funds. Customized target date series typically use investment managers hired to provide a specific risk exposure. Data about the performance of these funds is often not publicly available.
- Have benchmarking problems. Custom TDFs require custom benchmarks. How that benchmark is constructed is up to the advisor. I tend to favor benchmarks which are not able to be manipulated by the advisor. In other words, I trust, and so should you, publicly available benchmarks.
- Add complexity. A custom target date series brings an unnecessary layer of additional complexity to a 401k plan. These plans are already hard enough for participants to understand. Why make them more difficult?
- Seem to increase fiduciary liability for plan sponsors. As shown in the Intel case, it would appear that plan sponsors might more easily be sued if they end up with a poor performing customized target date series.
In my opinion, there is nothing so wrong with existing target date fund options offered by mutual fund families to warrant taking on the level of risk that appears to come with a customized target date series.
Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC. Mr. Lawton has over 30 years of retirement plan consulting and administration experience and has provided consulting services to many Fortune 500 companies including: Aon Hewitt, Apple Inc., AT&T, First Interstate Bank, Florida Power & Light, General Dynamics, Houghton Mifflin Harcourt, IBM, John Deere, Mazda Motor Car Company, Northwestern Mutual, Northern Trust Company, Trek Bikes, Tribune Company, Underwriters Labs and many others. Mr. Lawton may be contacted at (414) 828-4015 or firstname.lastname@example.org.
Lawton Retirement Plan Consultants, LLC is a Milwaukee, Wisconsin-based independent, objective Registered Investment Advisory (RIA) firm providing investment advisory, fiduciary compliance, employee education, vendor management and plan design services to 401(k) plan sponsors. The firm currently has contracts in place to provide consulting services on more than $400 million in plan assets. For more information, please contact Robert C. Lawton at (414) 828-4015 or email@example.com or visit the firm’s website at: http://www.lawtonrpc.com. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser.
This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance, tax, legal or investment advice. Each plan has unique requirements and you should consult your attorney or tax adviser for guidance on your specific situation. In no way does Lawton Retirement Plan Consultants, LLC assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations. Investors should carefully consider investment objectives, risks, charges and expenses. The statements in this publication are the opinions and beliefs of the commentator expressed when the commentary was made and are not intended to represent that person’s opinions and beliefs at any other time. The commentary does not necessarily reflect the opinion of Lawton Retirement Plan Consultants, LLC and should not be construed as recommendations or investment advice. Lawton Retirement Plan Consultants, LLC offers no tax, legal or accounting advice and any advice contained herein is not specific to any individual, entity or retirement plan, but rather general in nature and, therefore, should not be relied upon for specific investment situations. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser and accepts clients outside of Wisconsin based upon applicable state registration regulations and the “de minimus” exception.