Posted by Saaib Uppal, CPA
Having a target in mind is always a helpful approach when attempting to guide oneself towards a particular finish line. Whether it is a project around the house, a personal diet plan, or even career goals, targets assist us in making critical decisions. It seems all the more appropriate then, that we targeted the end of our blog series on missing participants and mandatory distributions to be the topic of “Target Date Funds.”
To recap, in our blog titled Mind Watching My Stuff for a Minute?, we introduced the scenario of a missing participant, the responsibility of the plan administrator to find him or her, and common search methods. What if the search methods are exhausted and you’re left with your palms facing the sky? We answered that question and went into alternatives in our second entry titled, Well, What do we do now?. We then announced the elimination one of the alternatives, the IRS letter-forwarding program, in Moving the Goal Posts of Humaneness. In Playing it Safe with Rollovers of Mandatory Distributions, we discussed automatic rollovers as one of EBSA’s preferred alternatives. As explained in the aforementioned blog entry, the Department of Labor (DOL) can look at the selection of the IRA provider and default IRA investments to assess whether the plan administrator is acting in the best interest of the plan participants. It is important for plan sponsors to understand the safe harbors provided by the Qualified Default Investment Alternative (QDIA) regulations.
In October 2007, the DOL released a fact sheet in which they provided for four types of QDIAs:
- A product with a mix of investments that takes into account the individual’s age or retirement date (an example of such a product could be a life-cycle or targeted-retirement-date fund);
- An investment service that allocates contributions among existing plan options to provide an asset mix that takes into account the individual’s age or retirement date (an example of such a service could be a professionally-managed account);
- A product with a mix of investments that takes into account the characteristics of the group of employees as a whole, rather than each individual (an example of such a product could be a balanced fund); and
- A capital preservation product for only the first 120 days of participation (an option for plan sponsors wishing to simplify administration if workers opt-out of participation in automatic enrollment plans before incurring an additional tax).
The first type is the option that we are targeting in this blog entry. Target date funds are investment funds that are designed to follow a “glide path.” The path targets the year in which the participant will turn 65 and presumably, retire. These funds are often offered in five-year increments and allocate participant money into stocks, bonds, and other mutual funds based on age.
While there is a common goal of reducing risky investments as the participant nears retirement and making the path more conservative, it is important to note that different investment companies still have different asset mixes. A recent survey by the Securities and Exchange Commission revealed that 54% of investors weren’t aware of the downside potential of the funds as they approach the targeted retirement date. Although employers can choose these target date funds as a safe harbor alternative, it is important for participants making active selections to understand the glide path of different target date options when deciding which one appears to be the most appropriate choice.
When evaluating the glide path, participants need to determine if the fund is intended to be a “to” retirement or “through” retirement investment. A “to” retirement fund will have its most conservative allocation at the target date while a “through” fund could hold their least risky mix anywhere from 7 to 30 years after the target date, depending on the investment company chosen. However, some “to” funds still hold a significant percentage of assets in equities at the target date. When evaluating the glide path, participants need to be aware of the allocation timeline of the fund in light of their risk tolerance and whether they intend to take a distribution of the entire balance at the target date or let it stay in the plan through their remaining life expectancy.
The change in risk along the glide path and at what point the fund will reach its most conservative allocation are just two factors to consider when selecting target date funds. These are in addition to the other targets that that we mentioned up until this point. Hit, and your selection will equal or exceed your expectations. Miss, and the fund’s earnings could fall short of your projections. Hopefully it is the former and that this blog series is just the ammunition you need to line yourself up and hit your target.