Target-date funds (TDFs) are so popular in the US that even the nation’s largest defined contribution (DC) pension system – the $400bn (€290bn) Thrift Savings Plan, the 401(k)-style retirement plan for federal staff – is thinking of making its TDF the default option for new employees. But with an increasingly diverse array of TDFs, concern is growing  among plan sponsors and advisers about the level of fiduciary responsibility involved.

At first sight, TDFs seem the simplest choice for both sponsors and participants. They replace the complex task of portfolio construction with a simplified option of an expected date of retirement, and provide automatic age-based rebalancing over time. As a result, they are an eligible qualified default investment alternative (QDIA) under the Pension Protection Act of 2006, and companies that automatically enrol employees in 401(k) plans are increasingly adopting them.

At the end of 2013, TDFs held $595.5bn in total assets – a fivefold increase since 2006, according to Morningstar. Casey, Quirk & Associates predicts that by 2020 their assets could represent nearly half of the projected $7.7trn in US DC. More than 40% of US DC plan participants use TDFs, according to the Investment Company Institute and the Employee Benefit Research Institute, and Cerulli Associates estimates that TDFs currently capture 42% of 401(k) contributions.

 Vanguard, which runs $165bn in TDFs, recently published research that shows the growing importance of these products on DC investment menus. In 2004, just 13% of Vanguard’s plan-sponsor clients had adopted TDFs, while the figure had grown to 86% in 2013. TDFs now make up 19% of total Vanguard DC plan assets and 34% of DC plan contributions. Some 70% of plans have specifically designated a QDIA, and nine in 10 of the QDIAs are target-date options. Nine in 10 plans with auto-enrolment are using TDFs as their default option.

The problem is that the risk profile of TDFs varies greatly, not only according to the target date but also depending on the kind of glide path the money manager uses. This is the formula used to adjust the mix of stocks, bonds and cash in relation to the target date. With the steepest glide path, so-called ‘To’ funds reduce the equity allocation to zero or close to zero on the retirement date. ‘Through’ funds, on the other hand, maintain a high stock allocation even after the retirement date, because their managers believe equity returns are the right solution to longevity risk.

A 65-year-old US female retiree will live a further 17.2 years on average, while a male of the same age will live a further 12.4 years, so they risk depleting their savings because of inflation and rising costs for medicine, housing and food. The average equity exposure at the target date for ‘To’ glide-path models is still 34%, versus 49% for ‘Through’ models, with extremes between the very conservative 28% for Wells Fargo to the very aggressive 65% for AllianceBernstein, according to Gregg Andonian, principal of Baystate Fiduciary Advisors.

After the 2008 financial crisis, participants in the most aggressive ‘Through’ funds who were close to retirement received a shock when the average 2010 TDF lost 23%, according to Morningstar data. On the other hand, TDFs performed very well in 2013, thanks to the bull market and their hefty exposure to stocks – funds with target dates of 2011-15 returned an average of 9.7%.

But if the plan sponsor sets a TDF as QDIA, which kind of glide path should the fund have? The choice implies considerable due diligence that must take into account employees’ age distribution, risk tolerance, income levels and withdrawal patterns, according to federal government guidelines. Otherwise, companies risk an explosion of litigation that Ronald Surz, president of Target Date Solutions, warns will take place after the next severe stockmarket downturn. For this reason, a new trend is for customised TDFs for individual companies.