A Challenge for TDFs: Cash Outs
A recent Fidelity study
found that in the 20 to 30 age group, 44% of all DC participants are cashing out after leaving employment. If financial hardships and subsequent cash outs from rollovers into DC plans and IRA accounts were included in the study, the amount of leakage would be much higher. Unfortunately, the age group with the greatest leakage is also the same group that receives the highest allocation to equities in a typical TDF glide path.
Though TDFs are often criticized for not taking into consideration outside assets and other risk factors, the bigger issue may be the cashing out of stocks due to an early withdrawal event. These “cashing out” statistics prompted Money
magazine, in an article titled, “The Conventional Money Wisdom That Millennials Should Ignore
,” to take the position that, “Many 401(k) plans automatically default young savers into stock-heavy target date funds, but they could just as easily start with a more traditional balanced fund, which holds a steady 60% in stocks and 40% in bonds. Perhaps higher risk strategies should be left as a conscious choice, for people who not only have a lot of time, but also a bit more market knowledge and a stable financial picture outside of their 401(k).”
What many perceive to be high equity allocations is one of the major challenges facing TDFs. Most of the criticisms have focused on the volatility of portfolios and how that may impact a DC investor who is risk sensitive (for whatever reason) and those on the cusp of retirement. This study by Fidelity brings to light an additional issue (or at least one that has not been aired much in the press) that would not work in favor of high equity allocations in TDFs.
The number one challenge of TDFs is that they are focused on essentially one risk factor: time-to-retirement. According to the author of the Money article, “The trouble is, most 401(k) plans don’t know much about an individual saver besides their age. The 401(k) is a blunt, flawed tool, and just putting different kinds of mutual funds inside of it isn’t going to solve all of the difficulties people run into when trying to save for the future.”
In the case of a target-risk fund (TRF), there is typically a risk-tolerance questionnaire which should be taken before selecting from the suite of TRFs. Information such as whether a DC investor has money set aside for an emergency and, thus, be more likely to cash in a plan or make a hardship withdrawal, is captured. The scoring mechanism takes such variables into consideration, matching participants with a risk appropriate fund.
Risk tolerance questionnaires are, of course, not as thorough as a complete financial plan. However, if designed properly and used by DC investors, age-to-retirement becomes one of the risk factors, not the risk factor.
Given that one-in-five workers plan to leave their employer in 2014
and considering few stay with a single employer throughout their entire career, the risk factor of an early withdrawal and the high potential of an early cash out should be factored into any asset allocation fund choice.
For a TDF user, there are three ways to diminish the impact of locking in losses due to early withdrawals:
- Switch to target-risk funds accompanied by a questionnaire (not optimal).
- As the Money article suggests, unless specifically requested, place everyone in a 60/40 balanced fund (not optimal).
- Design the TDF communication process so as to determine those DC investors who are likely to be short term (optimal).
The challenge essentially calls for a solution that retains the simplicity of TDFs while, at the same time, mitigating the risks associated with early cash outs and being forced to lock in losses. No doubt, this is an area in need of innovation.