Commentary: Target-risk funds experienced aggregate outflows of $2.9 billion during the second quarter of 2015, according to a recent report in an industry magazine. Are target-risk funds appropriate for 401(k) plans? I don't think so. Here's why:
What are target-risk funds?
Target-risk funds (sometimes called risk-based or lifestyle funds) are professionally managed, diversified investment options that target a 401(k) plan participant's risk level. Each participant must determine which target-risk fund is appropriate to invest in by taking a risk assessment quiz. Quiz results determine an individual's ability to bear risk (e.g., conservative, moderate or aggressive). This is different from target-date funds, where a participant's correct target-date fund option is determined by the date he/she will turn age 65.
What's wrong with target-risk funds?
Plan sponsors wishing to offer a professionally managed series of investment funds should note the following problems with target-risk funds that cause them to be vastly inferior to target-date funds:
- Participant inertia. Target-date funds use plan participant inertia (the tendency of participants to set-it and forget-it) in a positive way. Once a participant invests in a target-date fund, it is not necessary for him/her to make adjustments as time goes by. The opposite is true with target-risk funds. Participants have to identify the various points in their lives when their risk tolerance changes and choose to move to a lower risk fund. Most 401(k) plan participants have a difficult time judging when their ability to bear risk changes. Many are just too busy and forget to make adjustments. This is the most significant deterrent to using target-risk funds in 401(k) plans.
- Participants take on more risk than they should. Due to participant inertia, most participants end up staying in a higher risk option for longer than they should. As a result, they end up taking more risk than they have the ability to bear.
- Participants learn they are in the wrong fund at the wrong time. The absolute worst time for participants to learn they are invested in an option that is riskier than they thought is when they have suffered a loss greater than they can bear. This is a common experience for participants who have waited too long to move from a higher to lower risk fund.
- Participants become dissatisfied with the plan. As a plan sponsor, you know you typically hear from participants only when they have a bad plan experience. When participants have lost more than they thought they should because they were invested in a fund that took on more risk than they were able to bear, they will complain to you.
- Greater participant education responsibility. Participants need a significant amount of education to understand their ability to bear risk and the risk profiles of the target-risk funds available. For many participants, the concepts of risk and risk tolerance are very difficult to understand. Also, to be safe, should you administer risk assessment quizzes each year to all participants to catch those whose risk tolerance has changed? Do you have a fiduciary obligation to do so? Quizzing employees annually could become tiresome. None of this type of participant education is required when using target-date funds.
- Target-risk funds can be difficult to evaluate. Since many target-risk funds are comprised of the core fund options offered in a 401(k) plan, they end up being unique investment options that are difficult to evaluate. What is the appropriate benchmark for a moderately aggressive target-risk option comprised of your unique menu of core funds? Target-date funds don't suffer from these benchmark/evaluation issues.
As a result of these deficiencies, most plan sponsors use target-date rather than target-risk funds as their professionally managed QDIA compliant investment option. If you are currently using target-risk funds in your 401(k) plan, talk to your investment adviser about whether that approach is still appropriate.
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 firstname.lastname@example.org or 414.828.4015.
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