by Ron Surz
The short answer to this question is “Because their employers have chosen TDFs on their behalf.” Or more precisely, advisors choose TDFs (Target Date Funds) because employers rely on their advisors for this decision. Most assets are there by default. They belong to participants who can’t or won’t make an investment election. So why do financial advisors like them?
Prior to the Pension Protection Act of 2006 (PPA), the common default was plain old safe cash, but the PPA took cash off the table as a Qualified Default Investment Alternative (QDIA), establishing instead three safe harbors: managed accounts, balanced accounts (also known as target risk or target return), and target date funds.
The best QDIA is a managed account, tailored to the specifics of the individual investor, and the best managed account is face-to-face individual consulting, but this is expensive, so privately advised managed accounts are generally limited to the executives of companies. Managed accounts for the masses are available through firms like Financial Engines and Guided Choice but the actual experience indicates that many employees don’t use this advice at all or use it improperly.
The second QDIA, balanced funds, are typically target risk. Target risk funds haven’t been criticized much yet because they’re not that popular, and there are reasons for this lack of popularity. If the plan sponsor chooses one target risk fund for all of the defaulted employees, the one-size-fits-all criticism has real teeth. How can one level of risk be appropriate for both a 20 year old and a 65 year old? Or the plan sponsor could use a family of target risk funds, and place employees into risk groups, but then the sponsor needs some rules for mapping participants into risk groups, and an age-based rule makes sense. Bottom line, the sponsor would take on the role of moving defaulted participants into lower risk funds over time, which is what a target date fund is designed to do. A target date fund is a sequence of target risk funds on auto pilot.
TDFs do have real benefits, namely diversification and risk control, preferably at a low cost. All three benefits can be substantially improved, but they won’t be unless there is demand from financial advisors. In other words, target date funds are the preferred choice for good reasons, but they can and should be greatly improved upon.
To learn more about Target Date Funds download our FREE eBook Understanding the Hidden Risks of Target Date Funds and view our Infographic.
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