401(k) plan sponsors still are grappling with fallout from the financial market meltdown that not only hammered employees' account balances, but rattled their confidence in their ultimate prospects for retirement.

The apparent return to some semblance of normalcy, however, is giving employers and 401(k) service providers the opportunity to emerge from their bunkers and explore new approaches to delivering retirement benefits - as well as to validate or discard the old ones. And, given the inevitable squeeze on the corporate bottom line associated with a severe recession, 401(k) sponsors also are seeking ways to get by with less, asking vendors for concessions on fees or looking to more economical investment vehicle legal structures.

"We're looking for opportunities to reduce costs," notes Brant Suddath, director of benefits for Home Depot, whose 401(k) plan has about 150,000 participants and $2.25 billion in assets.

Like many plan sponsors, prior to the recent financial crisis, Home Depot switched to a target-date fund series for its default investment selection. And also like many employers, Home Depot took notice of the fact that high-equity allocations for target-date funds, even those intended for employees on the threshold of retirement or already retired, resulted in sharp declines when the stock market tanked.

"The market's performance gave us pause with regard to our 2010 fund and our 'in retirement' fund," Suddath says. "We did think about whether the assets were allocated appropriately. We're paying more attention to that issue," although not necessarily making any immediate changes, he adds.

More than a blip

Target-date funds (along with their cousins, asset allocation funds) totaled less than 10% of defined contribution plan assets at the beginning of the year, but about 22% of current participant contributions are earmarked for them, according to R.G. Wuelfing & Associates, an industry research and consulting firm. Target-date funds had been a mere blip on the screen prior to the 2006 Pension Protection Act, which sanctioned them as a qualified default investment alternative.

Last year, 53% of plan sponsors used target-date funds as their default option, according to the firm's president, Robert Wuelfing. But their rapid growth rate may be leveling off, he predicts. Still, he notes that plan participants increased allocations to target-date funds last year. He predicts target-date fund assets "will continue to grow, if for no other reason than inertia."

And perhaps inertia is not a bad thing when it comes to target-date funds, according to Mary Stringfield, national director of total rewards and benefits for Ernst & Young. The fact few of the "Big Four" accounting firms' 43,000 participants bailed out of their target-date funds during the market crash was probably good for them in the long run, she suggests, considering that most investors are terrible market timers.

Stringfield is a target-date fund fan. "I've been upset about all the negative press they've been receiving," she says, referring to articles suggesting that employees were ill-served by "high" target-date fund stakes in stocks.

But the real debate on target-date funds is focused not so much on the basic concept of a professionally managed, evolving mix of varied portfolios, as how that asset mix evolves as plan participants amble down the glide path toward retirement.

"An assessment of 2008 indicates that there may be times when investors may not be adequately compensated for their risk-taking in an extremely risky environment," concedes Richard Davies, head of product strategy for AllianceBernstein's defined contribution plan group. "That said," he adds, "our research shows a major reduction in the strategic equity allocation will prove quite costly in most periods as the longevity risk - the risk of outliving one's assets - will be increased."

T. Rowe Price, one of the largest players in the target-date fund market, drew the same conclusion after reanalyzing its own glide path strategy after the crash (see sidebar).

To or through?

As 401(k) plan sponsors and federal regulators have begun scrutinizing target-date funds more closely, the focus has shifted from raw performance numbers to the basic question of the target-date funds' goal - whether it is a "to" retirement or a "through" retirement target-date fund. The former simply seeks to deliver 401(k) participants to retirement's doorstep with a conservatively invested portfolio that retirees can then reinvest as they see fit. The latter, in contrast, assumes retirees will be drawing down on those funds steadily over the duration of their lives.

It appears that the federal government, if it regulates target-date funds, will focus on requiring target-date fund providers to make that distinction clear, rather than seek to micromanage target-date fund operations, according to Mark Warshawsky, director of retirement research for Watson Wyatt. Warshawsky testified at a joint hearing held by the Department of Labor and the SEC on target funds in April.

Paul Zemsky, who heads the Netherlands-based financial giant ING's asset allocation and multistrategy portfolios unit, says the company's advice "all along to plan sponsors was to have a pretty steep dropoff in the equity component into retirement."

But ING's suggested allocation for younger employees is more heavily tilted towards equities than the typical target-date fund, he adds. "Young people have an inherent bias toward fixed income if you think of the 'portfolio' of their entire life. Their biggest asset is their future income from work, with a future stream of cash from paychecks - it's like a bond."

ING's approach has a strong ally in Craig Israelsen, Ph.D., a professor at Brigham Young University and principal of Target Date Analytics. Israelsen and his colleagues devised a glide path strategy for a small series of target-date funds called "Smart Funds."

"The biggest providers assume, 'Of course, employees are going to stay in that fund after they retire,'" says Israelsen. "But we've never believed that. All the evidence is to the contrary."

Retire to a Winnebago?

Indeed, David Hand, chairman of Hand Benefits & Trust Company, which offers Smart Funds to its clients, says that most of his plan sponsor clients wind up making lump sum distributions of 401(k) assets to retirees.

"Most retirees sever their relationship to the employer after they retire, take the money and go on down the road. And you'd be surprised by how many of them don't roll it into an IRA, but use it just to pay down debt or buy a Winnebago."

That's why Israelsen believes 401(k) participants should be defaulted into a "to" target-date fund, employing a glide path such as his conservative model, which parks 40% of assets in cash and 60% in inflation-indexed Treasury bonds (TIPS) at retirement.

"We don't advocate that people stay at that allocation," he adds. "It's just a safe harbor for a few months until the retiree gets his head screwed on."

He also suggests retirees should be "defaulted into an appointment with a financial adviser" to help them determine the appropriate investment strategy, factoring in their entire financial picture, including assets outside the 401(k).

Finally, Israelsen urges plan sponsors to be wary of target-date fund providers that grant themselves the legal authority to alter funds' glide paths unilaterally, because in effect "it becomes an actively managed portfolio" if the manager isn't locked into a glide path.

But sponsors who don't like what they see in the off-the-shelf market are being encouraged to customize their target-date funds. "Based on what we're hearing in the marketplace, there is growing interest in customization, primarily in the large end of the market," according to Wuelfing. "This is due to concerns about widely varying performance as a result of divergent glide paths and concerns about fiduciary liability."

"We do tons of analysis for sponsors, looking at their plan populations, talking about customization," says Kristi Mitchem, head of the investment manager BGI's U.S. defined contribution plan business unit. But after the analysis is done, she adds, relatively few - about 20% - pursue customized approaches.

Target-date funds can be customized according to all the variables that distinguish them: by asset manager for each underlying asset pool (e.g. domestic growth stocks, international stocks, etc.), the asset mix for each allocation (i.e. how each broad asset class should be divvied up proportionately among sub-classes) and glide path.

Choosing customization

Often a plan sponsor will choose customization, Mitchem says, if it also has a defined benefit pension and wants to tap asset managers used for the defined benefit plan. Another reason to customize, she says, is the 401(k) contains a lot of employer stock, and the employer wants to offset that exposure with a more conservative overall allocation in the target-date fund.

Finally, Mitchem says employers may customize if their employees typically retire significantly earlier or later than the age 65 assumption baked into standard target-date fund offerings.

"There is a backlash going on relative to the fund-family-based target-date funds, because you don't have the ability to decide what goes in them," asserts Eric Levy, head of the DC plan outsourcing practice for Mercer. Plan sponsors have investment policy statements and need to ensure that the funds built into their target-date funds satisfy those guidelines, Levy argues.

AllianceBernstein is another champion of customized target-date fund solutions. "Large plans should design their own custom asset allocations to reflect the unique circumstances of their retirement plan design and the demographics of their workforce," says Davies.

But standard target-date fund offerings do not appear near extinction, even among large sponsors. "It sounds like a great opportunity, but it doesn't seem like there's a whole lot of penetration yet," says Home Depot's Suddath.

Stringfield is somewhat skeptical of the concept. "Our target-date funds are off-the-shelf. We did that consciously. You can make a more sophisticated product, but do people really need that? I wonder."

But as noted, plan sponsors are focusing on expenses - whether in customized or off-the-rack products. "Sponsors are looking for institutional fee structures and for the unbundling of the recordkeeper relationship," says Mitchem. "They may decide to use an index strategy on the defined contribution side, even if they use active management on the DB side," she adds.

And that would play to BGI's strength: BGI is a major player in low-cost index-based strategies, using the low-cost exchange-traded fund format.

Collective trust format

Yet other plan providers are also bringing low-cost approaches to market. For example, ING and others are deploying the collective trust legal structure for TDF offerings, instead of the mutual fund platform. "Large, sophisticated retirement plans may not need the protection and cost" of mutual funds, suggests Zemsky. He says a collective trust could save large sponsors as much as 30 basis points in asset management fees.

Perhaps trumping the issue of cost for some employers, however, is the matter of longevity risk: Will retirees run out of income before they run out of life?

"When you survey Americans about how long they're going to live in retirement, they underestimate the average by five years," says Davies. "Men think they're going to live to 83, when the median number is 87."

While employers appropriately anguish over glide paths and asset allocations to try to minimize longevity (and investment) risk, the new frontier may be incorporating insured annuity elements into target-date funds, with guaranteed minimum lifetime income streams.

Guaranteeing income

Following on Prudential's 2007 "IncomeFlex" offering that let 401(k) sponsors using Pru's money management servicesincorporate an annuity into their fund lineup, investment managers are preparing to make such options available under the broad target-date fund umbrella, if not the conventional target-date fund format.

"We are in the market for being able to deliver an annuity-based income product," reports ING's Levy. AllianceBernstein is working on an "open architecture" model that would let sponsors mix and match the insurance carriers and investment managers to create a customized longevity risk solution, Davies says.

And BGI is introducing a product, called "Sponsor Match," structured such that an increasing proportion of dollars that might otherwise be invested exclusively in bonds, as the fund matures, are designated for investment in annuity contracts. (At retirement, the employee can opt out of that annuity arrangement, however.)

The formula would be automatic for 401(k) funds employees ultimately receive via employer matching contributions, but employees could also invest in the same vehicles with their own salary deferrals. At retirement, approximately half of the employee's 401(k) assets might be available for annuitization.

But even as investment and insurance companies are seeking to outdo each other with better TDF mousetraps, many employers are still struggling with the perennial challenges of the defined contribution world. For Kathryn Holmes, HR manager for K&W Finishing in Baltimore, it's beating back "a ton of requests every week" from cash-strapped employees seeking hardship withdrawals or plan loans, prompted by the company's recent curtailment of overtime pay due to the slumping economy.

And at Home Depot, Suddath is trying to get more of the 110,000 eligible nonparticipating employees to join the 401(k) plan, but it's often an uphill battle when employees are sharing the burden of ever-rising health benefit costs. And he's probably not trying to win them over by singing the praises of the plan's nuanced asset allocation formula or target-date glide path.

Analysis: Avoiding 'risk' creates more risk

The question of how much equity exposure 401(k) participants should have at various points on the road to retirement was brought into sharp focus during the stock market crash. T. Rowe Price seized the occasion to re-crunch the numbers that led to the formulation of its target date fund glide paths, and published the results.

Few target-date fund critics question the appropriateness of high equity allocations for young workers. But what about those near retirement?

T. Rowe Price's asset allocation recipe calls for a 55% equity allocation at age 65, trailing off to a 35% allocation by age 80, gliding downward to 20% at age 95, and then remaining level.

Too risky?

No, concludes the new analysis.

T. Rowe Price's study emphasizes the variable of life expectancy. "In 2005, a 65-year-old couple had more than a 50% chance of one of them living to age 95," according to the study. "Retirees are not only living longer, but staying active longer, and that tends to increase their income needs.

"Another important consideration is the size of the 401(k) portfolio at retirement: The larger the portfolio, the more conservatively it can be invested.

"If retirees restricted their initial withdrawal to 4% of their nest eggs and increased each year's withdrawal amount each year by 3% for inflation, then even a very conservative, all-fixed income portfolio would provide a greater than 90% chance of not running out of money over 30 years," according to the study.

But what if the portfolio is relatively meager at retirement and an initial 4% withdrawal rate would not meet retirees' immediate income needs?

Unfortunately, "relatively few retirees have saved enough or are so restrained in their withdrawals ... because many investors under-save and overspend, they tend to need help from their portfolios," the study states.

Importantly, T. Rowe Price's new analysis incorporated the dismal 2008 financial market performance data that didn't exist when it originally designed its TDF glide path.But, the study is based on a key assumption: The glide path is intended for retirees "who do not intend to cash out their assets at retirement, but instead seek a stream of retirement income over their life spans."

In this article, the description of a target-date fund glide path for T. Rowe price incorrectly stated the target equity allocation for employees at age 65. The correct percentage is 55%. We regret the error.