Oversimplification in Target Date Funds Endangers Participants’ Retirement Savings How are custom solutions evolving to mitigate risk? Part III

Last month we featured Part II of Oversimplification in Target Date Funds Endangers Participants’ Retirement Savings – How are custom solutions evolving to mitigate risk? Part II introduced version 2.0 of target date funds (TDFs), an approach which allows plan sponsors to develop a glidepath best suited for their plan’s demographics. For the final installment of our three-part series, learn about version 3.0 of TDFs.

Addressing PaOversimplification-In-Target-Date-Fundsrticipants’ Different Needs and Goals

Clear evidence appears when looking at research and studies that show participants vary in their savings patterns, specifically in how much they defer from income today. This is key to estimating a minimum level of retirement savings needed to live on in retirement. Those who would like to live more extravagantly simply need to save more than this minimum amount. A recent Vanguard study² examined the deferral rates for all participants on their recordkeeping platform and found the following based on the median participant deferral rate of 6 percent:

• Participants deferring less than 6 percent: 53 percent

• Participants deferring 6–10 percent: 25 percent

• Participants deferring more than 10 percent: 22 percent

A participant’s savings rate is one of the largest factors to determine his or her total savings at retirement. Clearly, the assumptions to which version 1.0 providers and even version 2.0 plan sponsors have built their glidepaths do not accommodate the wide array of savings rates found within most plans. Therefore, this is the ultimate risk of TDF oversimplicity: only one assumed deferral rate. Many version 1.0 providers use what Vanguard identified as the median deferral rate, 6 percent. While plan sponsors may tweak this number to fit their demographics, this deferral rate typically does not change much because it is an average of a large population. The range of distribution is often misrepresented, which then exposes participants to the risk that they are not saving the assumed rate of deferral driving the investment solution.

Misfit Risk Is the Greatest Risk to Plan Participants

The simple, single-glidepath model that assumes participants all save at the same rate presents risks to participants’ retirement savings. The single glidepath creates a misfit between what an individual participant is doing and how the glidepath is managed for the plan’s entire participant population.

Version 3.0 addresses this misfit risk by giving participants multiple risk-based glidepaths from which they can select: aggressive, moderate and conservative. In this approach, the simplicity of choosing a retirement date is replaced by choosing a retirement date and an appropriate risk-based glidepath. For example, for the retirement date of 2035, there would be three glidepaths from which a participant can select: an Aggressive 2035 fund, a Moderate 2035 fund and a Conservative 2035 fund. The principal value of a target date fund is not guaranteed at any time, including at the target date.

Version 3.0 helps address the cost issue through an old but commonly found fund structure within retirement plans: the CIT structure.

CITs allow the custom TDF to look and feel like mutual funds, which have been the predominant investment vehicle for retirement plans. CITs carry a performance track record, have their own fact sheets, and are portable

across recordkeeping systems. Therefore, the CIT structure of version 3.0 combines the benefits of versions 1.0 and 2.0, while eliminating the misfit risk that participants accept by either selecting a TDF strategy based only on a retirement date or by being defaulted into the plan sponsor’s chosen single glidepath that represents some median or average participant but not the individual’s specific savings rate. At a minimum, version 3.0 presents participants with different allocation strategies, some carrying more risk than others. With education happening at the fund level in version 3.0, participants better understand that there is more to investing for retirement than just selecting a target retirement date.

Version 3.0 Removes the Risks of Oversimplification

The original and elegant idea of the TDF remains intact with version 3.0. The custom version 3.0 solution, with all its complexity, is actually not a difficult solution for the plan sponsor to implement and participants to understand. The most complex decision participants must make is selecting the date they expect to retire and the level of risk that is appropriate for their circumstances, solving for misfit risk. As TDF assets grow, expected to hit $1 trillion this year, misfit risk will only increase until more custom solutions like version 3.0 are adopted by plan sponsors and participants may have more choice because of it.

This material is from flexPATH Strategies’ white paper, Oversimplification in Target Date Funds Endangers Participants’ Retirement Savings – How are custom solutions evolving to mitigate risk? To view the white paper in its entirety, please click here.

ACR#191796 06/16