Four years ago, Chicago-based civil and environmental engineering firm Greeley and Hansen decided to take advantage of a new federal rule allowing companies to automatically enroll workers into their 401(k) plan.
Executives thought it was a great idea, but then came the challenge of deciding which investment would be most suitable for the firm's retirement plan. After reviewing several options, Greeley and Hansen settled on a family of target date funds offered by T. Rowe Price in Baltimore.
"We thought that target date funds would provide greater diversity for people who are automatically enrolled in the plan," says John Robak, executive vice president and chief operating officer at the company.
For many 401(k) participants in general, "inertia sets in and people forget about their investments" Robak says. "That's where target date funds do the job."
Greeley and Hansen's investment pick is similar to the offerings of many 401(k) plans. Target-date funds employ a mix of stocks and bonds that are put on a set glide path; over time, the investments in the fund automatically rebalance and get more conservative as workers near their targeted retirement date.
Because they are easy to understand (all employees need to do is match a desired retirement date to a target date fund), they have become popular with plan sponsors and participants.
Plus, target-date funds increase plan retention. A recent study by the Washington-based Employee Benefit Research Institute showed that nearly 96 percent of participants enrolled in target date funds in 2007 were still using them in 2009.
"Target date funds are a very easy way for participants to have a thoughtful, professional asset allocation that changes over time," says Toni Brown, director of U.S. client consulting at Mercer Investment Consulting's San Francisco office. "Most participants don't want to do their own investing and aren't capable."
The Pension Protection Act of 2006 fueled the proliferation of target date funds by allowing plan sponsors to use them as the initial investment to automatically enroll participants into their defined contribution plans. Since then, their growth has exploded, even through the 2008 market downturn.
By the end of 2010, nearly 64 percent of plans in the Profit Sharing/401k Council of America's annual survey offered target date funds, up from 44 percent in 2007. Target-date funds account for the second-largest portion of total assets in a plan at 13 percent, up from 4.5 percent in 2007. Actively managed domestic equity accounts for 25 percent of assets for all plans in 2010, the survey shows.
In 2020, target-date funds are expected to account for 48 percent of all U.S. defined contribution assets, compared with 12.5 percent in 2010, a recent report by investment consulting firm Casey Quirk & Associates showed.
"Target-date funds are a huge leap forward for most participants, relative to how they would allocate assets on their own," says David Bauer, partner at Casey Quirk & Associates in Darien, Connecticut.
Because more target-date-fund products are in the marketplace, expenses are dropping for employers. Average net expense ratios for target date funds have decreased since 2006.
Morningstar's study of 38 target date fund families shows an average net expense ratio of 1.12 percent on Sept. 30, 2011, compared with 1.23 percent in 2007. Some target date fund expense ratios can be as low as 0.20 percent.
Despite their popularity and lower prices, target-date funds have their critics.
Tom Bastin, president and general counsel for ERISA Fiduciary Advisors in Weston, Florida, says plan sponsors need to make sure the underlying investments in their target date funds don't conflict with the plan's investment policy statement.
For example, some investment policy statements require investment managers to have a certain number of years of experience, or don't allow certain asset classes. Target-date funds that conflict with a plan sponsor's investment policy statement could be open to participant lawsuits, Bastin says.
"There are fiduciary issues here," Bastin says. "In many cases, if target-date fund investments had to stand on their own, they'd fail the [investment policy] criteria."
For plan sponsors considering a target-date fund, knowing whether the fund goes to or through retirement is critical, experts say. Funds that go to retirement hit their most conservative asset allocation near the retirement date, while through funds don't hit their most conservative point until after the fund date name.
"Plan sponsors really need to have a good understanding of what they have so they can clearly communicate and monitor" their target-date funds, says Jeff Marzinsky, principal and investment consultant for Milliman in the consulting firm's Albany, New York, office. "If participants aren't aware [of the type of plan they are in], they may be taking more risk than they thought."
Patty Kujawa is a freelance writer based in Milwaukee. To comment, email email@example.com.