Sunday, August 02, 2009

Target Date Funds are not a "Magic Bullet"

My boss, the administrator of our company’s 401(k) plan, fearing fiduciary liability refuses to give our employees investment advice. Instead, he steers them towards our plan's target date funds. Much to his surprise, he recently discovered these funds are not the panacea they appeared to be.

A target date fund is simply a mutual fund with an asset allocation construed with a particular retirement date in mind. If you think you will retire in 10 years, you would pick a 2020 target date fund, with 2020 being roughly the year you plan to retire. It is the fund managers responsibility to reallocate your account from stocks to bonds automatically as your retirement date approaches, becoming progressively more conservative. These funds typically hold a mix of stocks, bonds and cash and will often include an allocation to foreign equities as well.

The latest economic downturn has revealed these funds are not a “magic bullet;” the reality is most of them are badly flawed and inappropriately allocated.

The problems include:
1. The asset allocation strategies and “glide path” vary dramatically among these funds.
No two target date funds invest the same way for the same retirement date. In fact, that's a major problem with them - take any two 2010 target-date funds and you may find one is 15% in stocks and the other is 60% in stocks. That makes a world of difference for someone retiring in 2010.

According to Tom Idzorek, chief investment officer and director of research at Ibbotson Associates, a Morningstar subsidiary, target-date funds differ dramatically in asset mix and in "glide path" — the rate at which the asset mix changes over time. "Participants who rely on date alone to choose a fund can have much more exposure to market volatility than they realize. Indeed, the percentage of equities in 2010 target-date funds ranges from 14% to 65%.

A target-date index created by Dow Jones determined a firm's asset class allocation for 2010 target-date funds should be around 27 percent in equities.

Performance statistics found in Morningstar indicate:
-The 2008 performance of target date funds ranged from -3.6% to -41.8%
-The 2008 average return -24.3%

-The 2008 performance of target date funds ranged from -31.1% to -41.8%
-The 2008 average return -37.9%

-The 2008 S&P 500 Index was -37.3%.

2. Many target date funds are stocked with mediocre funds:
Virtually all of these funds are made up of stock and bond funds within the same sponsoring fund family. Fund companies don't have a broad enough lineup of good funds to offer solid target funds so instead they use their lower rated funds that aren’t selling on their own knowing the typical target fund investor won’t probe deeper.

3. Higher fees:
Fees are higher because you are investing in target date funds that own other funds. Not only do you incur the fees of the target-date fund itself, but also the asset-weighted average of the management fees of the underlying funds.

4. One Size Doesn't Fit All:
The premise behind target date funds is that investors are supposed to place all their retirement savings into a single target date fund because one target date fund owns many other funds mixed together to form a specific asset allocation. They are not designed to be used in conjunction with other outside funds. They do not take into consideration a spouse’s 401(k), any other investments, risk tolerance or the actual date you plan on withdrawing your money which may differ from your retirement date.

When asked about my company 401k’s target fund, my financial planner immediately pointed out the above and insisted he could allocate my money more appropriately.

Investors have flocked to these funds ever since they began popping up in 401(k) plans. 40 % of defined contribution plans have target based funds and they are the most common default investment. The demand for target date funds stems from a lack of consumer investment knowledge. The typical consumer is increasingly responsible for funding his or her own retirement and is in dire need of guidance.

“Employees are most confused about how to allocate their investments.”
-401(k) Benchmarking Survey

What is a 401(k) plan sponsor to do?
Education that includes individual meetings and personalized communications are now cited as the most effective strategy for plan success. But beware, such specialized communication usually comes with a fee and one thing our 401(k) plans do not need is another fee.

The bottom line when investing your money; you can’t get away from being responsible for your own retirement. The best advice I can give is if your company provides individual education take advantage of it. It they don't, do the best you can to get your own advice. Visit a fee-only financial planner. Many offer a free consultation. Clark Howard recommends you go to to find a fee-only financial planner in your area. He suggests you interview three planners so you are comfortable with their way of investing. Also, get referrals from family and friends.

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  1. I found that my company is doing the same thing. Each employee is now automatically enrolled into a target date fund. The employee can then opt out or change it to whatever they want after it's opened. One thing I am grateful for is we had a "training session" on our 401(k). It wasn't anything great, but it was better than nothing and it got a lot of people thinking about retirement and their choice of investments.

  2. JohnMike11:09 PM

    Vanguard's Target Retirement Funds have none of the cons you've listed; Vanguard certainly has enough mutual funds in order to be diversified, and there is no 'double dipping'.