Customizing Target Date Funds

A recent study conducted by PlanSponsor and Janus Capital informed me that only about 1/3 of 401(k) plan sponsors (I think the actual number cited was 34%) think that Target Date Funds (TDFs) are the best Qualified Default Investment Alternative (QDIA) available. A year earlier, 57% were so enamored. That means that during a year that TDFs did not perform badly, approximately two-fifths of those who were on the TDF bandwagon fell off.

Why is that? Frankly, I'm not sure. The survey didn't ask them. Could it be that participant reactions to poor account performance come about a year in arrears? In other words, is there a natural time lag that occurs before the plan sponsor gets beaten up that goes something like this?

• Account balances decrease meaningfully
• Participant sees quarterly statement
• Participant finds last quarterly statement and compares
• Participant figures out which investment option he is in
• Participant asks 10 best buddies who to complain to
• Between them, they narrow down to the right person
• Complaints start pouring in 
• Plan sponsor sours on TDF as QDIA

Even in the best of years, however, one could question whether TDFs are an appropriate default investment vehicle. In the Pension Protection Act of 2006 (PPA), Congress came to a four-step conclusion:

1. 401(k) plan Participants who don't make an affirmative election regarding their in-plan investments should be defaulted into an appropriate fund
2. That fund should not be the same for all participants
3. Instead, it generally should be appropriate and the same for all participants of the same age who think they will retire roughly at the same time
4. It should be constructed in a way that is appropriate for a participant of that age

It left a few options out there. The investment manager who develops the TDF gets to decide what is an appropriate asset mix. A firm who is both a recordkeeper and an investment manager can nearly force a lot of money into their TDFs (some do this far more than others). A TDF can be 100% proprietary; that is, the TDF created by Really Powerful Investment Manager (RPIM) can be nothing but a mix of RPIM funds that already exist. TDFs need not take any parameters other than expected retirement year into account.

This cannot be the best answer. I repeat, this cannot be the best answer.

When I become President of the United States, a majority of both houses of Congress, and Secretary of Labor, it won't be the answer. Don't hold your breath waiting for any of that to happen. Even if I were an otherwise likely candidate for any of those positions, that I speak my mind freely in a forum like this would disqualify me.

So, consider this, the hint of the century (bonus points if you know who I stole that from, I'll tell you later). Not all 37 year olds who think they will retire in 2040 are similarly situated. Some have savings. Some don't. Some participate in defined benefit plans. Some don't. Some are homeowners. Some aren't. Some have kids. Some don't.

Let's just assume that the tie between recordkeepers and investment managers is not going to be broken. If that's the case, then proprietary TDFs will remain widespread. It may not be perfect, but I just can't see the whole industry losing its religion (that's a big hint, by the way). But, suppose that RBIM is the recordkeeper for the 401(k) plan that I participate in. And, suppose that the TDF family run by RBIM was the plan's QDIA.

But, let's throw in a few changes. Let's throw in a modeler. Now, each 37 year old who thinks they are going to retire in 2040 is going to tell a computer model something about himself. And, the model is going to take all this information and build a more appropriate TDF for that participant. And RBIM will change the name of its company to Really Excellent Manager (REM). 

Oh, and if you are looking for the answer to the trivia question that popped up earlier, you already have it.