When working with your advisor to review the investment strategies for your 401(k) plan, many companies default to using Target Date Funds as the main option in their retirement plan.
Target Date funds are a great solution and a huge improvement over the old way of giving employees a list of funds and asking them to create a strategy on their own.
While Target Date Funds are a great solution, Plancorp believes there is another solution worth considering for some companies based on risk tolerance.
A Risk Tolerance strategy gets a bit more granular, offering a portfolio allocation based on an individual investor’s personal risk tolerance and financial goals. Depending on the level of engagement across the company we recommend this option to many of our Corporate Retirement Plan clients.
In this article, we’ll compare target date funds to the approach based on risk tolerance. We’ll cover the basics of each option as well as the pros and cons so you can make an informed decision about what investment portfolio options work best for your company and employees.
What is a Target Date Fund?
Target date funds are relatively straight forward, both in definition and in practice. They simplify retirement investing by adjusting asset allocation from aggressive to conservative over the years as you approach your chosen retirement date, or ‘target date.’
Early in an employee’s career, a target date fund will likely be aggressive. These funds typically stay aggressive for the first 15-20 years of an employee’s career operating under the general assumption because you are farther away from retirement, you’re comfortable with and will benefit from a strong tilt toward equities in your portfolio.
Then, the funds begin reducing their allocation to stocks, and increasing allocation to bonds, gradually as an employee approaches their retirement date. Depending on your type of target date fund (“to” or “through”), the allocation may continue to become more conservative after the portfolio reaches its target date.
Pros of Target Date Funds
Set it and forget it: Target date funds are the simplest to manage as they only require plan participants to choose a target retirement date once at plan inception. There is no need to go in and adjust their asset allocations over time.
Good for plans with a large number of participants: Companies with a significant number of employees, and therefore plan participants, often find target date funds to be a good choice for the business. They don’t necessarily have the time or resources required to individually advise their employees on selecting plans; so a strategy that generally works for most people can be the simplest and best solution in this case.
Cons of Target Date Funds
One size does not fit all: Target date funds don't consider any information besides an employee’s retirement year when allocating assets. This can become a problem when you consider different employees’ savings strategies and prioritization of retirement goals. Let’s look at an example:
Employee A and Employee B earn the same annual salary and are roughly the same age. They are each invested in a 2055 Target Date Fund.
Employee A is a great saver, investing 15% of their income in the company’s 401(k) plan. Employee B, however, has other financial priorities in their life, like student loan debt, to contend with. They're only able to contribute enough to get the company match, let’s say 4%.
In this scenario, Employee A will be much further ahead of Employee B in terms of account balance as they reach retirement age. Therefore, Employee A can afford to take their foot off the gas and invest in less risky portfolios. Employee B, on the other hand, would need a more aggressive and risky strategy to reach the same end goal.
With only a target date fund option on the table, Employee A is taking on unnecessary risk, and Employee B is at a disadvantage until they can afford higher contributions.
This is just one example but you can understand how two employees with similar planned retirement dates might not benefit from the same asset allocation. Their saving patterns, financial priorities, or risk tolerance may differ.
What is a Risk Tolerance Strategy?
Another strategy for a diversified, managed portfolio that is an all-in-one solution for employees is the Risk Tolerance Strategy.
If you’re considering offering these types of portfolios in your company’s retirement plan, you’ll likely see options with names such as Aggressive, Conservative, Moderate and more.
Within each risk tolerance level is a static portfolio of funds that is regularly rebalanced, typically on a quarterly basis. The actual asset allocation of each strategy depends on the provider of the strategy, but generally this offers progressive options that employees can choose from to match their needs.
Pros of Risk Tolerance Funds
Customizable: Unlike target date funds, plan participants control their risk level over time. They can determine, often with the help of an advisor, which option is best for them based on their age, goals, savings rates, assets, and more. As those circumstances change, they can move between target risk funds to control their risk level.
Good for plans with a smaller number of participants: With a smaller number of participants in the plan, it is often easier for advisors to do the education necessary for risk tolerance funds to make sense. While more customizable than Target Date Funds, Risk Tolerance Funds do require employees to consider their circumstances, their own risk tolerance, and make an active choice.
At Plancorp, meeting one-on-one with plan participants is a key differentiator of our corporate retirement planning services. A company 401(k) is only as good as its ability to help its participants reach their goals, and we believe that customized portfolios are a crucial component of successful retirement saving.
Cons of Target Risk Funds
More participant engagement required: Unlike target date funds, “set it and forget it” isn’t the best approach for a risk tolerance strategy. It’s recommended that plan participants revisit their portfolio allocations at least annually to make sure they still align with goals and risk tolerance.
Which Fund Type is Right for Your Company’s Plan?
Both Target Date Funds and Risk Tolerance Strategies are great options for retirement plan participants. They both provide an all-in-one, diversified solution that participants should not need to review more than once a year or in consideration of a life event.
When considering what works best for your plan there are a few things worth reviewing.
Cost:
Both Target Date and Risk Tolerance Strategies can be low-cost. The costs of these funds should be limited to the expense ratio of the underlying funds that are utilized. Any management fees layered on top of these funds, if any, should be extremely small.
Be aware that many advisors like to promote “Managed Models” as options for employees. Managed Models sound like Risk Tolerance Strategies, but they are much different.
Managed Models can charge significant fees to participants for their use. They purport to offer much more personalized portfolios than Target Date or Risk Tolerance Strategies, but Plancorp has found that the cost of that personalization can be extremely high.
Employers should be ensuring their participants receive value from any investment or tool utilized in the retirement plan.
Participant Engagement:
Risk Tolerance Strategies make most sense when your employee base is engaged with your retirement plan. This can be affected by the location dispersion of employees, age, income, career path and more.
We have found that in-person meetings with time set aside before or after for our team to meet with employees, creates great engagement and participants feel confident in their Risk Tolerance Strategies when we have the opportunity to work with them.
One solution we often suggest for some companies is utilizing BOTH Target Date and Risk Tolerance funds. For employees who do not engage, Target Date funds provide a great default option. But if an employee does engage, they can customize their risk level as their life changes.
Advisor Support:
Part of the value of Risk Tolerance Strategies is employees understanding their own risk tolerance and personal financial situation enough to make a confident choice.
We find this is often not possible if a retirement plan does not have advisor support where employees can sit down with someone and learn how these decisions are made and given the knowledge and tools to make that choice.
This also may present an opportunity to review if your advisor is giving you the support you deserve. Plancorp often finds we can provide all of our services, including employee support, for the same cost or less than an advisor who does not do these things.
Our team specializes in helping clients run great 401(k), 403(b), and Cash Balance Plans. We know unique companies require unique solutions. We’ll help you take your retirement plan to the next level.
Ready to benchmark your fees and see if you can increase the ROI of your retirement plan? Get started today.
