Retirement is an important life event, but it is not the end point of a lifetime investment plan.
Successful long-term investing requires consistency, discipline, and diversification. In offering a 401(k) plan, companies provide consistency by allowing employees to systematically save every pay period through automated payroll deferrals. Discipline is demonstrated when employees elect to join or stay in the plan. The missing component is often diversification, an effective mix of uncorrelated asset classes.
For most people, the act of investing is uncomfortable; for some it's even scary. When faced with something they don't understand (or something they fear), inertia often takes over and people may fail to take any action. The key to helping employees create an effective mix of investments in their 401(k) account may be to let someone else decide just what that looks like. Once the right investment strategy is set, inertia can work for, rather than against, the investor.
One solution is the target-date fund (TDF), sometimes known as a lifecycle fund. A TDF invests similarly to the way an individual investor who has plenty of time and an understanding of asset allocation might. In the early years of the TDF, when the investor is young and can afford to take more risk, the fund will hold a greater concentration of stocks. As the fund (and the investor) ages, the investment mix shifts toward less risk by automatically reducing its holdings in stocks and increasing its fixed income holdings.
TDFs Within 401(k) Plans
TDFs have emerged as a top choice for 401(k) plan investors, because they offer an easy way for participants to achieve diversification with one simple selection. Ideally, plan advisors would be aware of each investor's holdings outside the plan so those assets can be considered within the overall investment strategy. Even without that knowledge, though, TDFs can help address any gaps in investment classes held by the investor, because TDF fund managers often use a wide variety within the funds they manage.
TDFs are popular as 401(k) plan Qualified Default Investment Alternatives, or QDIA, in part because they can provide a degree of fiduciary protection to the plan sponsor. When the plan uses automatic enrollment, participant deferrals and matching contributions must be invested in an appropriate default fund for each individual investor. Rather than allocating the capital to a fund that is too aggressive or too conservative, a plan sponsor can direct the money into a TDF whose investment mix is appropriate today as well as in the future.
Evaluating Key Differences
As TDFs play a more integral role in 401(k) investing, plan sponsors may wonder about differences between funds offered by different fund companies. What, for example, is the difference between Fidelity's 2035 fund and Vanguard's 2035 fund? While the purpose of this paper is not to make specific fund or company recommendations, Regions clients can be assured that our open architecture approach means we review and evaluate the marketplace, and recommend the funds we believe to be the best fit for them.
The fund companies' underlying investment philosophies play an important role as they construct their TDFs, and they play an important role in Regions' decisions about recommending them to our clients. The investment philosophy drives the differences in TDFs from one firm to another. One of the chief differences between funds is their stance on investing 'to' the retirement date versus 'through' the retirement date.
Fund providers using a 'to' strategy generally reach their lowest equity allocation at the point the fund reaches its target retirement date. When that occurs, the balance between stocks and fixed income investments (and usually a minimal amount of cash) is designed to be very conservative with only enough stock holdings to try to maintain value. Fund managers of 'to' funds anticipate that investors will withdraw their funds at that time in favor of an annuity or another investment designed to carry the participant through the retirement phase of his or her life.
On the other hand, managers of 'through' funds typically design their products for participants who wish to draw down their retirement accounts gradually rather than all at once. These participants may need to sell only a small portion of their investments each year to meet their retirement living expenses, and want to keep the rest invested with some possibility for growth. By investing less conservatively at the target date than 'to' funds, 'through' funds may be more likely to take advantage of market gains.
For most investors, we believe a 'through' fund can be beneficial because it allows the investor to maintain consistency at the point they begin to draw down their investments. Investors who reach their target retirement date are at a critical point in their lives and should not be, in essence, forced to make a decision about moving their 401(k) account into another fund at this crucial stage.
What About Target-Risk Funds?
Historically, investors were called upon to decide whether their investing style was aggressive, moderate or conservative. Once they selected their risk profile their assets were invested in a fund that was designed to meet the goals of investors in one of those three categories. These were often called Target Risk Funds (TRFs). There are a couple of reasons we at Regions usually recommend our clients explore TDFs rather than TRFs.
First, investors' risk designations tend to be made emotionally rather than rationally, like so many other investment decisions. For example, investors who identify themselves as aggressive when the market is doing well may feel very differently the day after a stock market correction – and understandably so. As investors age, they are likely to want to change their investment strategy, becoming more conservative as they get closer to retirement. With a TRF, investors will be required to decide when their current allocation is no longer appropriate, and actively make an election to move to a more conservative allocation. When investors have other decisions to make or distractions in their lives, taking the time necessary to sift through the options and make these critical decisions can result in inertia. In turn, inertia can mean carrying too much risk, thus jeopardizing the participant's assets – and retirement.
Regions believes TDFs can be an easier solution, one that takes the ongoing decision-making out of the equation. Using a TDF instead of a TRF means an appropriate investment strategy at any age, with a single decision at the outset.
Regions' Position
We believe Target-Date Funds should be available in most 401(k) plans, as a Qualified Default Investment Alternative and as an investment choice. 'Through' funds are generally preferable to 'to' funds, because they allow the participant to continue their established investment strategy without the added pressure of changing course when their target date is reached.
Still, all plans are different and it is our strong contention that each should receive the attention of an experienced, qualified advisor/consultant to optimize its design and investment menu. Please contact your Regions consultant to learn more about how we can help.
