Participants in employer-sponsored retirement plans, such as 401(k) plans, often express they do not want the responsibility of constructing their own investment portfolios for their savings goals. The investment industry responded by offering two types of asset allocation funds to provide all-in-one solutions: target date funds and risk-based funds.

Target date funds are designed to decrease risk as the participant approaches retirement; for example Fidelity Freedom 2020 Fund. They state the year when an investor plans to retire. During the life of a target date fund, the fund manager will gradually reduce the risk by decreasing stock holdings and increasing bond holdings. This is referred to as a “glide path.”

Risk-based funds do not have glide paths and do not target a retirement date; they target a specific amount of portfolio risk. Fund managers usually offer four or five funds that span a risk spectrum from very conservative to aggressive by using varying mixes of stocks and bonds that remain fairly static within each fund. The higher the proportion of stocks in a fund’s mix, the more aggressive it is designed to be. How should someone choose the better option for their situation?

Plan sponsors whose participants have little time, interest or knowledge about investing and are not exposed to investment advice or education usually prefer target date funds. It is relatively easy for a person to choose a timeframe when they will retire. Furthermore, the Department of Labor shows a bias toward target date funds over risk-based funds when selecting a qualified default investment alternative (QDIA), meant to protect investors who do not make an investment election. Target date funds may be a better solution for the “set it and forget it” investors.

However, target date funds have drawbacks too. Different managers use varying glide paths based on their perspective about how much risk a typical participant should take at a given time. This makes it difficult for both plan sponsors and advisers to select, benchmark and monitor these funds because they cannot compare apples to apples. It also could cause participants to take an inappropriate level of risk inadvertently. For example, some glide paths are designed with asset allocations that will get them to retirement while others are designed to get them through retirement.

Registered investment advisers who prefer risk-based funds generally do so in order to avoid the limitations of target date funds. It is much more meaningful when comparing one company’s funds with another when they share a similar asset allocation and investment strategy. This allows them to confidently monitor the funds and advise their plan sponsors accordingly. For the participant, it is important that they are able to decide which risk-based fund to use. Advisors may help them make these decisions by testing their risk tolerance and conducting group and individual education.

Risk-based funds offer greater flexibility to cater to participants’ needs because they are static and straightforward. They operate under rules that keep their composition of stocks, bonds and cash within certain ranges defined by their investment objective as stated in the prospectus. Investors who want to change their investment strategy, either to a more aggressive or more conservative approach, can easily do so by calculating the difference between their chosen stock and bond holdings. There is an observable change from one risk-based fund to another. With target date funds, that decision becomes more complicated because the rate of change on the glide path is not constant, is usually almost zero in the distant future and speeds up as retirement approaches.

Regardless of which approach is chosen, it is wise to stick with one to avoid confusion. Most choose asset allocation funds because they provide a simple diversified solution, but it is ultimately up to plan sponsors with the help of an investment adviser. As fiduciaries to a retirement plan, the sponsor and their investment adviser should weigh the benefits and pitfalls of each to determine the most benefits for the plan and the participants.

		Cameron J. Cichocki, AIF® is a retirement plan investment adviser for PensionTrend Investment Advisors, LLC, headquartered in Okemos. PTIA provides investment advisory serves in a fiduciary capacity to more than 200 qualified employee retirement plans.