Why 401(k) plan sponsors shouldn’t use custom TDFs

Commentary: Recently, it has become popular for large corporations to adopt customized target-date fund approaches for their 401(k) plans. Before jumping into why this approach has never made much sense to me, it might be good to start out with a couple definitions.

What are target-date funds?

Many mutual fund families have created an integrated series of investment funds with dates in their names. The dates approximate the time period that a participant will turn 65 and retire. These professionally managed investment funds vary their bond/stock allocation percentages as time goes by so that as a participant gets closer to age 65 his/her allocation becomes more conservative. Target-date funds are generally considered to be the most appropriate investment for the vast majority of 401(k) plan participants.

What are custom TDFs?

A custom TDF series uses a unique set of underlying investments and/or alters the bond/stock percentages significantly for the different funds in the series. These different bond/stock allocations are based upon demographic assumptions unique to the employer. The intent is to create a non-standard glide path for the target-date series.

Also see: “Weighing the pros and cons of a custom target-date strategy.”

Why I don't like custom TDFs

I have never understood why plan sponsors find customized target-date fund approaches appealing since they may:

Result in much higher costs. Although a selling point of a customized approach is often the ability to lower overall fees, that isn't always the outcome. Use of a customized series may in fact result in much higher adviser fees due to the time and effort required to construct the customized series and the extra research required to produce quarterly performance reports.

Use inappropriate investments. As demonstrated in a recent lawsuit against Intel, where private equity and hedge fund investments were used to construct a custom target-date series, a plan sponsor may find that the underlying investments an adviser recommended are not appropriate. The types of investments used in the Intel plan appear to be very high-cost for plan participants and very lucrative for the advisers.

End up white-labeled. A customized target-date series essentially becomes a white-labeled set of funds with all the negative attributes that result from white-labeling. The funds are no longer transparent to participants, cannot be reliably benchmarked and are not easily understood by plan participants.

Also see: “White-labeling investment funds is a bad idea.”

Be constructed based on questionable assumptions. The notion that future non-standard retirement activity can be modeled accurately is nonsense. A frequent reason cited to adopt a customized approach to target-date funds is because of demographic differences in an employee population that are expected to result in retirement patterns that are non-standard (e.g., a lot of retirements sooner or later than age 65). It seems nearly impossible to me to be able to predict the retirement patterns for a specific demographic group 30 or 40 years from now with any degree of accuracy. As a result, how can any adviser say that a certain set of bond/stock splits is more appropriate than what is being used in a standard set of target-date funds?

Be less transparent. Although greater transparency is an argument used for constructing a customized series, it is likely that most participants will have far less of an understanding of the investment managers selected in a customized series. Most standard target-date series use mutual funds as the underlying investments. Data is publicly available for nearly all mutual funds. Customized target-date series typically use investment managers hired to provide a specific risk exposure. Data about the performance of these funds is often not publicly available.

Also see: “Plan sponsors get serious about TDF selection.”

Have benchmarking problems. A custom target-date series will require a custom benchmark. How that benchmark is constructed is up to the adviser. I tend to favor benchmarks which are not able to be manipulated by the adviser. In other words, I trust, and so should you, publicly available benchmarks.

Add complexity. A custom target-date series brings an unnecessary layer of additional complexity to a 401(k) plan. These plans are already hard enough for participants to understand. Why make them more difficult?

Seem to increase fiduciary liability for plan sponsors. As shown in the Intel case, it would appear that plan sponsors might more easily be sued if they end up with a poor performing customized target-date series.

Also see: “Small business lobbies Congress to alter DOL fiduciary rule.”

In my opinion, there is nothing so wrong with existing target-date fund options offered by mutual fund families to warrant taking on the level of risk that appears to come with a customized target date series.

Robert C. Lawton, AIF, CRPS is president of Lawton Retirement Plan Consultants, LLC, a RIA firm helping retirement plan sponsors with their investment, fiduciary, employee education and compliance responsibilities. He may be contacted at bob@lawtonrpc.com or 414.828.4015.