People don’t always use target-date funds (TDFs) appropriately, said Wei-Yin Hu, vice president of financial research at Financial Engines, speaking at the PLANADVISER National Conference in Orlando, Florida, on Tuesday. TDFs are “a nice all-in-one solution,” he said, “and can provide a long-lasting investment outlook. But are people getting the benefit?”

Unfortunately, about 40% of participants drop out of the vehicle, some because of market turmoil, when they lose 5% or 10%. “They don’t have anyone to call,” Wu said, “and they do things on their own that hurt them.” By comparison, managed accounts as a solution see less drop-off, he observed. “Nothing is perfect, but there is a sharp difference.”

Another problem: partial allocation. Typically, participants put only a part of their portfolio in TDFs, Hu said, citing statistics showing that just 4% of assets in TDFs are used appropriately. The funds are predominantly used by young, newly enrolled participants with smaller balances. People leave over time and do not go in with large balances. 

Participants grow reluctant to keep all their assets in one investment, Hu observed. “If there’s one thing they learned, it’s ‘Don’t put all your eggs in one basket,’ without realizing there are exceptions.”

The design of these funds is good, but actual participant behavior is where they fall down. “People can’t talk to a TDF and are tempted to chase performance and panic in down cycles,” Hu said.

Analyzing TDF usage is the most valuable skill a plan adviser brings when working with the plan sponsor to get to the right qualified default investment alternative (QDIA), according to Ben D. Jones, managing director at BMO Global Asset Management. “Unfortunately, a lot of plan sponsors don’t give that decision the reverence it deserves,” he said. “They choose the recordkeeper solution or the cheapest solution.”

The key, Jones said, is determining the plan objectives. How paternalistic is the plan? Does the sponsor want to have a guided plan, or is it more interested in being self-directed?

Plan advisers can add a lot of value by providing scenario analysis and analytics to walk plan sponsors through the decision matrix, Jones said. Plan sponsors are unlikely to revisit a decision, so it’s advisable to have different trigger points throughout the life cycle of that client to revisit the funds and make sure the plan objectives are still met. “Many TDFs have changed their [investment] philosophy entirely over the last decade,” Jones pointed out.

Advisers have the hardest job of anyone in the industry, trying to select the appropriate TDF for a plan, said James Macey, senior vice president/portfolio manager at Franklin Templeton Investments. TDFs have myriad complexities to analyze, from the variety of asset classes they invest in to the underlying managers, differences in glide path construction and methodology, proprietary versus nonproprietary or strategic versus tactical. “What is the right amount and balance of those things?” he asked.

“We as an industry need to do a better job on the participant side,” Macey said. “Plan sponsors need to educate their work force; advisers need to do a better job, and portfolio managers have to do a better job helping to explain the risks and rewards.”

Evaluating target-date funds is an evolving process, Macey said. Firms differ on how they evaluate TDFs, but most importantly the smartest advisers understand that choosing solely on performance and fees is no longer on the table.

Another pitfall is participants who benchmark their TDFs to the Standard & Poor's (S&P) 500. “Then,” Macey said, “they freak out over low returns. But the S&P is not an appropriate benchmark for a TDF, and certainly not when [a participant is] older.” He also emphasized that good advisers understand past performance foretells nothing.

Ultimately, Hu reminded the audience, the plan sponsor wants employees to get to a successful retirement. “We as advice providers report to our plan sponsor clients on how we impact participant outcomes,” he said.