Examine Your TDFs’ Glide Paths to Ensure Suitability
Retirement plan fiduciaries generally are absolved from liability with respect to plan participants’ selection of investments in plans that offer multiple investment choices with various levels of risk. This includes target date funds (TDFs). Fiduciaries’ duties with respect to TDFs were fine-tuned under the Pension Protection Act. However, fiduciaries must still act prudently in selecting TDFs.
ABCs of TDFs
A key element in a TDF’s design is its glide path. This is the scheduled asset allocation evolution from a more aggressive posture to a more conservative one as the target date nears. Plan fiduciaries should make sure they understand the TDF’s glide path, including when the fund will reach its most conservative asset allocation and whether that occurs on or after the target date.
Some TDFs maintain a significant equity allocation at the target date, while others don’t. Generally, the former are for employees who don’t expect to withdraw their entire 401(k) plan savings immediately on retirement. Ideally, few, if any, employees would do so other than to roll the fund into a similarly invested IRA.
TDFs with minimal equity exposure at retirement are suitable for those employees who want or need to cash out. Fiduciaries must be confident that participants understand the glide path when deciding to invest.
In addition, fiduciaries should review TDFs on a regular basis (as they would any other investment) to determine whether to continue offering them to employees. Consider whether any circumstances have changed with regard to the plan and its participants since selecting the TDF array. Also, if the plan’s objectives for offering a TDF change, it may be prudent to replace the fund.
How can you assess the appropriateness of a TDF’s glide path? An important way is to understand what the TDF manager says about its methodology for determining its glide path. Russell Investments recently issued a report detailing its analysis of that very topic, which resulted in a fine-tuning in its own glide path models.
Russell’s research summarized five “key findings”:
- Participants’ contribution and earnings patterns. Educated guesses about how much money participants ultimately will have in their accounts at retirement influence glide path decisions. Lifetime contributions will be “significantly” higher than originally assumed, based on a projection of greater employer contributions to employees’ accounts and higher employee final salaries.
- Participant spending patterns in retirement offset retirement income. While a retiree’s spending evolves over time, the analysts found it generally decreases each year until about age 80. Russell dropped the proportion of retirement income derived from Social Security to 30% from 36% to reflect an individual benefit instead of a couple’s benefit.
- Unexpected retirement costs. Analysis of retirees’ health care costs led Russell to increase its projection of “target income replacement” — what participants need to shoot for as a percentage of their final preretirement income — to 79% (49% from sources other than Social Security).
- Low interest rates and bond yields. Russell found that the prolonged period of low interest rates and bond yields has forced savers to bear extra risk to realistically attain a real positive rate of return.
- Modest allocation changes. Some modest changes to allocations to growth assets within the TDF’s glide path may improve participant outcomes.
Time to Analyze Your TDF
Different TDF providers may look at the same or other data and draw different conclusions. Fiduciaries should review the TDF glide paths offered by their plan and determine whether it reflects today’s market and retirement expense realities. And be sure your investment policy statement clearly states whether the TDFs are your plan’s default option and how they were chosen. This will go a long way toward properly discharging your fiduciary duties.
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