Why is this Topic Important to Wealth Managers? This topic discusses a relatively new form of retirement investment offered by companies to their employees. The topic presents information about target date funds, what they are, who may use them and how they work. The defined contribution retirement market is a prime location for wealth managers to earn fees and commissions. Thus, staying informed about new market updates is provided to give managers an edge when exploring retirement benefits.
The Government Accountability Office recently published a report stating that financial security of millions of Americans in their retirement years will substantially depend on their savings in 401(k) and other defined contribution (DC) plans.  The GAO notes, to help ensure adequate financial resources for retirement, participants in DC plans should make adequate contributions during their working years and invest contributions in a way that will facilitate adequate investment returns over time.
To that end, the Pension Protection Act of 2006 (PPA) included various provisions designed to encourage greater retirement savings among workers eligible to participate in 401(k) plans, such as provisions that facilitate plan sponsors’ adoption of automatic enrollment policies. 
Under such policies, eligible workers are automatically enrolled unless they explicitly decide to opt out of participation. Because an automatic enrollment program must also include a default investment—a vehicle in which contributions will be invested absent a specific choice by the plan participant—the act also directed the Department of Labor to assist employers in selecting default investments that best serve the retirement needs of workers who do not direct their own investments. Since that time, target date funds (TDF)—that is, investment funds that invest in a mix of assets, and shift from higher-risk to lower-risk investments as a participant approaches their “target” retirement date—have emerged as by far the most popular default investment.
TDFs are designed to provide an age appropriate asset allocation for plan participants over time. However, target date funds vary considerably in asset structures and in other ways, largely as a result of the different objectives and investment philosophies of fund managers. In the years approaching the retirement date, for example, some TDFs have a relatively low equity allocation—35 percent or less—so that plan participants will be insulated from excessive losses near retirement. Other TDFs have an equity allocation of 60 percent or more in the belief that relatively high equity returns will help ensure that retirees do not deplete savings in old age.
TDFs also vary considerably in other respects, such as in the use of alternative assets and complex investment techniques. In addition, allocations are based in part on assumptions about plan participant actions—such as contribution rates and how plan participants will manage 401(k) assets upon retirement—which may differ from the actions of many participants. These investment differences and differences between assumed and actual participant behavior may have significant implications for the retirement security of plan participants invested in TDFs.
Moreover, recent TDF performance has varied considerably, and while studies show that many investors will obtain significantly positive returns over the long term, a small percentage of investors may have poor or negative returns.  Between 2005 and 2009 annualized TDF returns for the largest funds with 5 years of returns ranged from +28 percent to -31 percent. Although TDFs do not have a long history, studies modeling the potential long-term performance of TDFs show that TDFs investment returns may vary greatly. For example, while one study found that the mean rate of return for all individual participants was +4.3 percent, some participant groups could experience significantly lower returns. These studies also found that different ratios of investments affect the range of TDF investment returns and offer various trade-offs.
TDFs offer investors a number of potential advantages. First, they relieve DC plan participants of the burden of deciding how to allocate their retirement savings among equities, fixed income, and other investments. Thus, TDFs offer participants a professionally developed asset allocation based on their planned retirement date. TDFs thereby can help plan participants and other investors avoid common investment mistakes, such as a lack of diversification and a failure to periodically rebalance their assets.
Second, TDFs are designed to strike a balance between an age-appropriate level of risk and potential investment return. In general, a TDF provider will include a series of funds designed for participants expecting to retire in different years, such as 2010, 2015, 2020, 2025, and so on. A plan participant who is 30 years old in 2011, for example, might be defaulted into a 2045 TDF, while a 55-year-old participant would likely be defaulted into a 2020 TDF. Typically, a TDF will shift from primarily equities to fixed income investments as a participant approaches his or her retirement date, in the belief that fixed income investments generally pose lower risk. This shift can be represented graphically as a line commonly referred to as the glide path.
TDFs are often established as mutual funds in a fund-of-funds structure. That is, the TDF is a composite of multiple underlying mutual funds in different asset classes. Generally, TDFs consist of an equity component and a fixed income component.
The major asset classes, in turn, may be composed of funds representing different sectors of the major asset classes. For example, the equity component may consist of some funds focused on equities of large U.S. corporations, international equities, or equities of smaller companies. Similarly, the fixed income component may consist of various bond funds, such as funds consisting of government and corporate bonds.
Tomorrow’s blogticle will continue to discuss new and exciting planning aspects of 2011.
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Government Accountability Office. “Defined Contribution Plans–Key Information on Target Date Funds as Default Investments Should Be Provided to Plan Sponsors and Participants”. January 2011. GAO-11-118. http://www.gao.gov/new.items/d11118.pdf
. Last Accessed 2/28/2011.
 Pub. L. No. 109-280 (2006) Section 902 of PPA added Internal Revenue Code sections 401(k)(13), 401(m)(12) and 414(w); Automatic Contribution Arrangements, 74 Fed. Reg. 8,200 (February 24, 2009) (to be codified at 26 C.F.R. pts. 1 and 54).
 See GAO-11-118 at 121 “GAO representation of Morningstar data”.