Why Target Date Funds Don’t Always Hit the Mark
In the days when pensions were prevalent, employers would set aside savings for their workers, invest the assets and then reward employees with a lifetime income at retirement. In 1981, with the advent of the 401(k), the retirement savings responsibility shifted to the employee. Workers decided how much of their wages were to be set aside and then faced the task of how to invest the savings from a menu of investments offered by the employer-sponsored plan.
Now, once again, the tables are turning. Employees are generally puzzled by investment options and frequently unwilling to learn much about them. The growing demand has been: "somebody needs to do this for me." Target date funds (TDFs) -- also known as "lifecycle" funds – offer a solution. Unlike a pension, TDFs do not provide a guaranteed income, but they can do the heavy lifting of investing for those uninterested in doing it on their own.
Setting a date
The concept seems simple enough: pick the date you intend to retire, select the corresponding fund – and you're done. For example, a Target 2035 fund, built for a worker looking to retire some 20 years from now, would be more aggressively invested than a Target 2020 fund, designed for an employee about five years from retirement.
Each target date investment is comprised of many unseen, interior moving parts: stock mutual funds for growth, bond funds for income, and money market funds to hold cash. Younger investors have a greater mix of stock funds, which have a higher potential return, as well as more risk. Older workers would typically hold more income producing investments, with less risk but a lower expected return.
Because target date funds automatically adjust their investment mix, or allocation, as retirement approaches, they would seem to be a simple and effective solution for investors without the time or inclination to do it on their own.
Not only do TDFs fine-tune their holdings to dial-down risk as retirement approaches, they also rebalance investments as markets rise and fall. For example, during the financial crisis of 2008 when the stock market tanked, many investors rode the market down, seeing their stock mutual fund allocation shrink. Facing anxiety and uncertainty, some wondered if they should buy in to the market at its low levels? More likely they sold their stock funds to "stop the bleeding." But target-date funds rebalanced and added equity holdings, and as the market recovered, so did TDFs.
However, pre-fab funds don't take into account an investor's risk appetite, income, job security, current savings rate or balance, or other investments.
To retirement or through retirement?
Not all target-specific investments are built the same. The Securities and Exchange Commission notes that among funds that were designed for a 2010 target date, losses in 2008 ranged from 9 percent to 41 percent -- while returns in 2009 ranged from about 7 percent to 31 percent. Those are big differences in performance.
The varied investment allocations employed by assorted mutual fund providers, and the manner in which they adjust their investments over time – called the "glide path" – can account for some of the broad gaps in performance.
It's also a matter of whether the fund is designed to provide a "cash-out" balance at the target date, or a "live-through" investment mix. Some investors intend to cash out their investment at retirement, perhaps rolling over the assets to an IRA or annuity. Others may leave the investments intact, aiming for more growth prior to tapping the nest egg for income.
Any investment that is wrapped inside another investment adds a layer of fees – and that's been one of the knocks against target date funds. The good news is, the average expense ratio dropped to 0.91 percent in 2012, down from 0.99 percent in 2011, according to Morningstar.
In fact, Vanguard and Fidelity, two of the biggest providers of TDFs, are in a bit of a price war. Fidelity recently lowered its fees to just 16 basis points in order to undercut the Vanguard target date funds charge of 18 basis points. Since both providers are using index funds as their underlying holdings, fees can be kept to a minimum. TDFs holding "active" mutual funds that attempt to outperform broad-market indices are more expensive.
Studies have proven that a proper investment mix is the single most important factor in portfolio return. If you are a "do-it-for-me" investor, target date funds may be a good off-the-shelf solution.
Neda Jafarzadeh is a financial analyst for NerdWallet, a site dedicated to helping investors find the right brokerage account or mutual fund for their investments.
Photo courtesy of iStock photo.