For the purpose of this article, target-date mutual funds come in two "flavors": those that anticipate being cashed out at the plan's retirement age and those that do not. However, it seems to me that 401(k) plans mainly have one flavor: those that cash out at retirement.

By “cash out,” I mean that, when a participant retires and takes a distribution, the plan sells the target-date fund in his account and issues a check to the IRA designated by the participant. The retired participant then has to make an investment decision. Will he reinvest in a similar target-date fund? Will he buy an annuity to provide income for life? Will he invest in mutual funds, but different from the mix in the old target-date fund?

This presents several questions for fiduciaries, like plan committees. First, and most important, which flavor of target-date fund do you have? If you don’t know, you need to find out—fast. That question focuses on one of the key issues fiduciaries need to consider in selecting target-date funds: the glide path.

Some target-date funds, typically the more conservative ones, build their glide paths to end on or about the anticipated retirement age of the participant, the “targeted date,” like 2010, expecting that the participant will take the money in cash—either personally or in an IRA—and make a new investment decision. That design reflects a belief that neither the manager of the target-date fund nor the plan sponsor knows what the participant’s retirement investment decision will be. As a result, a significant objective for the fund is to preserve capital over the last 10 years before retirement, so that it is not subject to a high degree of volatility and, therefore, does not expose participants to the potential of large losses close to retirement.

Other target-date managers structure their glide paths to continue beyond retirement, sometimes to age 75 or later. Those fund managers apparently anticipate that the participant will take a distribution at retirement, but then roll over to an IRA and immediately reinvest in the same fund or a similarly designed portfolio. If that is the case, the participant will have an opportunity to recover from any losses incurred shortly before his retirement. However, if the participant rolls over and invests in a more conservative way or buys an annuity, there will never be an opportunity to recover fully from the pre-retirement losses.

As a result, it is critical that fiduciaries understand the competing philosophies of target-date managers, make decisions about which approach is appropriate for their plan, and identify high-quality target-date funds that are structured accordingly.

There appears to be an emerging consensus that—to answer that question—fiduciaries should focus on the glide path for the 10 years prior to the targeted date. So, at this point, committees should be looking closely at their 2010, 2015, and 2020 funds. What is the asset allocation? How do they compare with other target-date families? Do they have a higher percentage in stocks or in bonds? Many 2010 funds lost 25% or more in 2008; is it acceptable to you that your near-retirees lost that much of their retirement income so close to their retirement dates?

Once you have examined your target-date family and compared it to others, the next step is to examine the needs of your plan and your participants. Is your workforce highly educated and well-paid? Do your employees understand and tolerate stock market volatility? Is your company—and your workforce—flexible on retirement ages, so that workers can continue for another three to five years, if necessary? Or, are your workforce characteristics low pay, high-school-educated, fearful of losses, lacking in understanding of investment and economic cycles, and somewhat inflexible at retirement?

Finally, will your employees select conservative investments in retirement or will they continue to put most of their investments in stocks? Will they have professional advice?

These questions—and the answers—are essential parts of a prudent process for selecting target-date funds.

Disclaimer Required by IRS Rules of Practice:
Any discussion of tax matters contained herein is not intended or written to be used, and cannot be used, for the purpose of avoiding any penalties that may be imposed under Federal tax laws.

Source: PLANSPONSOR magazine