Last month, the Department of Labor issued a document titled “Target Date Retirement Funds – Tips for ERISA Plan Fiduciaries”, which provides guidance to plan sponsors evaluating target date funds (“TDFs”). Among other tips, the DOL tells plan sponsors:
“You should consider how well the TDF’s characteristics align with eligible employees’ ages and likely retirement dates. It also may be helpful for plan fiduciaries to discuss with their prospective TDF providers the possible significance of other characteristics of the participant population, such as participation in a traditional defined benefit pension plan offered by the employer, salary levels, turnover rates, contribution rates and withdrawal patterns.”
There are several different ways of thinking about how the characteristics of the eligible employees might affect the preferred level of risk in a glide path. They can be thought of through different lenses, such as time horizon, wealth levels, integration with other assets, etc. There are many ways to think about these issues, and here are some of our thoughts about how the characteristics of the eligible employees might affect the level of risk in a glide path:
Longevity: Plan populations with higher longevity—such as those with more females and highly paid employees—are suited to take more investment risk than the typical participant because of their longer horizons.
Retirement Age: Populations with earlier average retirement ages, which are often associated with governmental plans and jobs requiring significant physical labor, can have higher risk tolerances (for the same target retirement date) because of longer post-retirement horizons.
Salary Levels: There are two sides of this issue. On the one hand, those with below-average incomes (and wealth levels) may have a lower risk tolerance by virtue of having a smaller financial cushion in the event of poor outcomes. Alternatively, Social Security provides a greater proportion of retirement income needs for those with low incomes, which may allow them to take more risk in their DC plan. Individual circumstances would dictate which of these factors should dominate.
Contribution Rates: Plans where the populations contribute less, as a percentage of pay, may want to have lower risk levels in their target date funds because their populations have smaller financial cushions. In addition, populations with low contribution levels may also experience later retirement ages, which we previously noted might also be associated with lower risk tolerances (for the same target retirement date) because of shorter post-retirement horizons.
Turnover/Withdrawal Rates: Higher employee turnover and withdrawals (and loans) from the plans are associated with leakage and lower savings levels over a career, which should be correlated with lower risk tolerances for the same reason as lower contributions.
Defined Benefit Plans: The existence of a defined benefit plan would typically suggest a higher risk tolerance for the investments in the defined contribution plan, as the defined benefit plan can be considered to represent the low-risk portion of the participants’ total wealth. This can be especially tricky for plan sponsors to evaluate when some employees have benefits in a defined benefit plan and others do not, which is often the case when plan sponsors close and freeze their defined benefit plans.
In practice, different indicators may point in opposing directions for most plan sponsors, creating additional challenges. Regardless of the outcome, plan sponsors should not simply assume that the glide path that is right for other populations is also right for theirs.
As a solution to this issue, the statement from the Department of Labor also gave a nod to custom target date funds, suggesting that plan sponsors:
“Inquire about whether a custom or non-proprietary target date fund would be a better fit for your plan… There are some costs and administrative tasks involved in creating a custom or nonproprietary TDF, and they may not be right for every plan, but you should ask your investment provider whether it offers them.”
We agree that this can be an effective way to develop a glide path that is appropriate for the unique characteristics of a particular population. While the preferred TDF approach will vary, the most important thing is for fiduciaries to be thoughtful about their specific circumstances and choose the option that is best for their participants.
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