Surprisingly, many plan sponsors have not implemented any process to select target-date funds. (Photo: Shutterstock)

With the continued growth of target-date funds showing no signs of abating, retirement plan sponsors will want to review their plan offerings to ensure they are meeting the savings needs of their employees.

Two important factors have contributed to the surge in target date funds:

1. They are often the default investment option for many defined contribution plans
2. They are easy for most employees to understand.

The numbers below from research firm Cerulli Associates tell the story:

• 88% of new contributions, representing 35% of total 401(k) assets, will be invested in target-date funds by the end of this year
• Target-date fund investments will total $2 trillion by year-end

While target-date funds are among the most common offerings in defined contribution plans, when you dig a little deeper you soon learn they are also the most widely misunderstood:  by plan sponsors (many of whom believe they are all similar); by participants (whose understanding of how they work is all over the map); and even investment advisors (who may not have access to the research tools necessary to properly evaluate the funds for suitability for participants).

We believe there is potential – and substantial – fiduciary liability exposure for plan sponsors in this area, particularly when the next market downturn occurs.  This may be an upcoming focus of litigation, especially since the Department of Labor has clarified how plan sponsors are expected to select and monitor target-date funds.

Surprisingly, we've come across many plan sponsors who have not implemented any process to select target-date funds.

You can't judge a target-date fund by its name because they are not created the same. They can vary significantly in how managers allocate between equities and fixed income assets and the risk profile of those securities.

The challenge is to help plan sponsors determine which ones are best suited for their employees. Here's how you do it:

1. Review plan objectives when selecting target-date funds.

This may seem like a no-brainer, but trust me, it's important to take this step. Companies have different needs when it comes to their retirement plans. The risk profiles for employee populations vary from employer to employer, and the target date funds offered must be based on participant demographics, risk and behavior.

The good news is that the DOL guidelines provide you a roadmap for this step.

2. Research plan demographics.

Our research suggests that participants who make their own investment decisions don't maintain the appropriate asset allocation during the course of their working lives.

Many younger workers may not have enough exposure to equities given their long-term investment horizon, while older workers may have too much. There can also be a wide distribution in the equity exposure of participants within a similar age range.

That's why it's vital that plan sponsors and advisors obtain and analyze retirement plan data to get an accurate picture of the investment needs of their participants. The results of that research will guide you in determining the appropriate risk profiles among the different target-date funds.

3. Analyze participant behavior.

Plan sponsors and advisors need to understand the investment behavior of participants and how they are using their retirement plans. Analyzing such behavior – for example, differences among newly hired single employees, employees with growing families and employees nearing retirement – will shed light on their profile for risk and preference for higher versus lower equity exposure near retirement.

This type of pragmatic research can be applied to help select the most prudent target-date fund for a plan's specific goals and objectives.

Target-date funds are an excellent option for employees who want simple and effective investment options to achieve their retirement goals.

Following these tips will help ensure that employees receive the right mix of target-date funds that also pass the scrutiny of regulatory agencies.

Brad Knowles is managing director for Heritage Retirement Plan Advisors, a Registered Investment Advisor with the SEC that specializes in providing fiduciary and investment advisory services to employer sponsored qualified and non-qualified retirement plans. Brad began his financial services career in 2001 and founded his own retirement plan advisory firm, RBK Capital, in 2014. Brad joined joined Heritage in 2016 and is one of around 50 advisors nationally who have earned the Certified Behavioral Finance Analysts (CBFA) designation. Brad earned his Master of Business Administration and Bachelor of Science degrees from the University of Oklahoma.