A few weeks ago I commented on some of the issues we had with Target Date Funds (TDFs) http://oldperfessorsinvestmentblog.blogspot.com/2012/01/target-date-funds-and-your-401k-part-1.html . This week I’ll share the protocol that I use to evaluate whether or not to recommend that clients use the target date funds available in their 401(k) plans.
1. Determine the clients risk tolerance
2. Develop an asset allocation based on risk tolerance
3. Develop a portfolio using the non-target date funds available in the plan. Note that I have run across plans that are so poorly designed that it is not possible to design a properly diversified portfolio.
4. If TDF’s are available in the plan, identify the fund whose asset allocation most closely matches the one developed from the client’s risk tolerance … not the one whose target retirement date most closely matches the client’s.
5. Compare the past performance of the TDF with the performance of the portfolio assembled from the non-target date funds in the plan.
6. If the TDF has consistently outperformed the portfolio put together using the non-target date funds or it is not possible to put together a decent portfolio using the non-target date funds then you should use the TDF. Note that past performance is no indication of future performance; it is, however, along with common sense, all we have to base decisions on.
7. If we identify a TDF that looks like it might be an effective investment tool for that client, then we look at the underlying fund investments and check for diversification and management quality. One issue with TDF’s is that some fund families have used them to gather assets for in-house funds that have performed poorly and have difficulty attracting assets on their own. This however will show up in poor performance relative to properly designed competing portfolio.
This is the only protocol that properly evaluates all of the options available to a 401(k) plan participant. The bad news is that it represents a fair amount of work, more that most 401(k) participants are willing to do. The above protocol takes me about 4-5 hours and I have been doing research like this for over 20 years. Further, I know of very few plan vendors that supply plan participants with the research tools to follow the above protocol to make a rational and informed decision about the use of a target date fund, while my practice spends a great deal of money annually on independent research so we can make effective, unbiased decisions for our clients.
One of my pet peeves is people who write lengthy criticisms but offer no solutions. So if you are a participant in a 401(k) plan that offers target date options or you already own one, here’s what you should do.:
1. Make the commitment to thoroughly understand the options in your plan. Use the protocol I have outlined above to evaluate the use of target date options in your plan.
2. If you are unwilling or unable to make the commitment, seek out an independent, fee-only financial planner in your area and hire them to evaluate your plan and make recommendations. A good place to start your search is The Paladin Registry, an independent evaluator of planners http://www.paladinregistry.com/ .