Auto-enrollment has emerged as an effective way to drive 401(k) plan participation. As a result, the importance of a plan’s default investment has increased significantly. Currently, target date funds (TDFs) are the leading default investment alternative for 401(k) plans. TDFs have become what some may consider the “easy button” when it comes to default investments, but there are other types that could be a more prudent fit and should be considered.

Prior to passage of the 2006 Pension Protection Act (PPA), most sponsors, out of an abundance of caution, defaulted investment to either a money market fund or a GIC – so as to ensure that participants who had made no affirmative choice as to how to invest their money (or even as to their plan contribution rate) didn’t lose anything.

Dissatisfied with this ultra-cautious approach, Congress, in the PPA, instructed the Department of Labor to develop regulations "on the appropriateness of designating default investments that include a mix of asset classes consistent with capital preservation or long-term capital appreciation, or a blend of both." Those regulations, finalized in 2007, signified that sponsors would be less susceptible to fiduciary risk if participant contributions were defaulted to one of three “qualified default investments” (QDIAs):

• "Target maturity-type" funds, defined as "an investment fund product or model portfolio that applies generally accepted investment theories, is diversified so as to attempt to minimize the risk of large losses and that is designed to provide varying degrees of long-term appreciation and capital preservation through a mix of equity and fixed income exposures based on the participant's age, target retirement date (such as normal retirement age under the plan) or life expectancy."
• "Balanced funds," subject to the same general rules as "target maturity-type" funds except that the asset mix did not consider an individual participant’s age but only the demographics of the participant group as a whole.
• Individualized "Investment management services."

Since 2007, target date funds (TDFs) (as "target maturity-type" funds are now called) have emerged as the go-to 401(k) plan default fund.¹

Too often, however, sponsors and their financial professionals opt for a generic TDF design that primarily focuses only on two asset classes – US equities tilted towards large cap (as the “higher risk” asset class) and US investment grade fixed income (as the “lower risk” asset class). And the TDF’s glide path design simply forces (for a given age cohort) a mechanical stock/bond split between these two asset classes, depending on the participant’s age cohort or target retirement age.

The result of all this is multiple age-based investment “buckets” and an investment design that manages to be both overly simplistic and overly complicated.

This simplistic, two-asset class approach often does not reflect, e.g., fixed income duration risk or inflation effects. More critically – as with most passive investment approaches it ascribes a simple, binary risk factor to the two asset classes, without adjusting for, e.g., increases/decreases in stock or interest rate market volatility. Finally, most TDFs have very limited diversification within the two risk-on/risk-off asset classes – there is, for instance little exposure to non-US securities.

All of this worked when – as was the case since 2008 and until very recently – US interest rates remained at historic lows, and US markets outperformed the alternatives.

But as interest rates have risen and the rally in US markets has “paused,” the value of diversification as a hedge in down markets has become clear to us.

We think it’s time to think more deeply about risk, as something other than stocks vs. bonds or simply passively accepting large cap beta. Critically it’s time to think about risk as not just involving interest rates and stock markets but also the effects of inflation, volatility sequence of returns and rising rates.

In that context, we believe there may be a better default investment solution than the typical TDF. With most 65-year-olds living well into their 80s – the “power” of adjusting risk based on age may be overrated. And TDFs’ more simplistic view of risk as a basic function of binary fixed percentages of stocks vs. bonds may be inadequate for the current retirement landscape.

As an alternative, we would suggest it’s time to think about another sort of QDIA – a balanced fund – run on traditional (and “generally accepted”) investment principles, with a diversity of investments – very much including non-US investments – and with an active concern for what is an appropriate investment in choppier markets. Instead of the faux-science of a (somewhat artificial) age-based investment horizon, a balanced fund that seeks long-term appreciation while seeking – through a diversity of investment classes – to minimize the risk of large losses.

It’s a QDIA that, while still simple in its design, is both more intuitive and more adapted to a variety of market conditions.