The Department of Labor’s new fiduciary standard has had a far-reaching effect on the retirement planning industry, even though it will not go fully into effect until April 2017. One of the ways that it is impacting advisors is that it requires them to reevaluate the characteristics of all types of investments, including target date funds. Advisors who formerly thought that they could fulfill their fiduciary duty by simply putting their clients in the cheapest investment available must now take a second look at some of these options in order to make sure that they are carrying out business in a more holistic sense.

Here's more detail about how target date funds and the advisors who peddle them will be impacted by the new rule. (For related reading, see: Why Fiduciary Rule Revisions Are Rankling Advisors.

A New Perspective

Advisors who once based their investment recommendations solely on fees will now be required to conduct a due diligence process that goes beyond a simple choice between active and passive management. All target date funds are actively managed in a sense, so advisors who embrace a purely passive style of money management may be prohibited from using these instruments.

The key issue to consider with target date funds is their glide path, which will primarily determine the amount of risk and return within the fund. This path is chosen by the money manager, and different managers will choose different paths even for funds that have the same target date. One manager may take a much more aggressive approach in the asset allocation for a fund, whereas another manager may take less risk and provide a lower return. For example, there has been a deviation of nearly three quarters of a percent between the returns posted by five major funds with a target date of 2020.

Advisors need to be cognizant of these discrepancies and look beyond the fee structure in these funds and analyze their underlying asset allocation to make sure that they stay within the bounds of their clients’ risk tolerances. Those with higher risk tolerances are candidates for the more aggressive funds, while risk-averse clients will need to use a more conservative choice. And when it comes to evaluating the amount of risk that comes with a given fund, it is necessary to determine the fund’s exposure to various asset classes. Target date managers that take a more passive approach will most likely be less diversified that those that take a more active approach, because some asset classes, such as alternative investments, are hard to reproduce or use with a passive strategy. Advisors need to know whether the fund manager is taking a more strategic stance with asset allocation, and whether the manager is able to make immediate adjustments in the portfolio in response to current market conditions.

A final consideration that advisors need to know is the structure of the fund’s architecture. Some target date funds only use one asset manager for all of their underlying investments while others use multiple managers, which may provide superior diversification.

The Bottom Line

Advisors who consider the factors listed above can better serve clients by using target date funds that not only come with low fees but also genuinely fit their clients’ investment objectives and risk tolerances. Target date funds that have open architecture may see continued growth because they can provide access to the best money managers and will have the ability to replace money managers if necessary. Open architecture funds can have an array of managers that provides the investor with a low alpha correlation and the ability to benefit from differing styles of portfolio management. (For related reading, see: The Fiduciary Rule: What Will Implementation Cost?)