Mutual funds with a projected retirement date attached have been sold as a panacea to people saving and investing for retirement via a 401k, IRA or brokerage account. But are they? Despite their growing popularity among 401k investors, target date retirement funds have some very big problems. Let’s analyze them.
Target Funds: A Background
Since first being introduced in the mid-1990s, target date funds have experienced significant growth and have attracted around $270 billion. In the U.S., Fidelity Investments, T. Rowe Price and the Vanguard Group command more than 75 percent of the market for target date retirement funds.
The basic idea behind target date retirement funds is to help investors own a diversified portfolio of assets that is rebalanced over time. The asset allocation for target date retirement funds is automatically adjusted by the fund’s portfolio manager to reflect changes in a person’s age, risk tolerance and investment goals. This process is commonly called the fund’s “glide path.”
Target date funds with an investment horizon of ten years or more will typically hold a greater portion of the portfolio in growth investments like stocks whereas funds with a time horizon of ten years or less will own a greater portion in income producing assets like bonds.
Most people choose a target date fund that’s near their projected retirement date. For example, a 55 year-old person who plans to retire in ten years might select a retirement fund with the year 2020 (NYSEArca: TZG) as its target date.
Benefits of Target Funds
The usage of target date retirement funds inside 401(k) retirement plans has become widespread, especially since the Department of Labor and the Pension Protection Act of 2006 designated them as “qualified default investment alternatives.” This labeling provides liability protection for employers who sponsor a 401(k) plan that use target date funds as a default investment option for employee participants.
Aside from limiting a 401(k) sponsor’s liability, target date funds simplify the investment process for retirement savers who aren’t comfortable making their own investment choices.
Problems With Target Funds
Conceptually, the idea of target date funds is good but their execution has been a mixed bag. In 2008, funds that were close to reaching their target date and were supposedly conservative in their asset mix suffered significant losses. And even today there continues to be a disparity in returns among target date funds with identical target dates.
“Although the 2009 returns were positive, the differences between 2008 and 2009 returns demonstrate significant volatility,” noted the Securities and Exchange Commission in a summary of proposed rules. “In addition, 2009 returns, like 2008 returns, reflect significant variability among funds with the same target date.”
Drawbacks for Investors
One of the biggest strikes against target date funds is that they sell the false idea that one size fits all. For instance, a fund manager’s asset allocation could be inappropriate for your personal situation or it may fail to keep up with economic changes and other circumstances such as job loss, unexpected expenditures, and serious illness affecting life expectancy.
Two other major problems are nepotism in the selection of underlying investments and fees.
Regrettably, most mutual fund companies employ a closed architecture strategy by offering target date retirement funds using their own proprietary mutual funds. These underlying funds many not necessarily be the best choice for investors, especially if they’re actively managed funds with consistent underperformance.
The other issue is fees, and with average annual expense ratios close to 1.25 percent, most target date retirement funds are all but guaranteed to underperform against blended benchmarks containing stocks and bonds over the long run.
Lastly, the strategy of target date funds once they reach their “landing point” is cloudy. For many funds, their asset allocation becomes static. Is a static asset mix really in the best interest of investors?
The Future of Target Funds in 401k Plans
Target date retirement ETFs have made excellent strides at greatly reducing investor’s costs. BlackRock’s offers a series of seven iShares target date ETFs with average annual expense ratios of just 0.30 percent. The funds have target dates with five year increments from 2010, such as the iShares S&P Target Date 2010 Indx Fund ETF (NYSE: TZD) to 2040 via the iShares S&P Target Date 2040 Indx Fund ETF (NYSE: TZV) and they use iShares ETFs as the underlying investments.
Unfortunately, most 401(k) investors don’t have access to low cost ETFs because their employers don’t know any better or because they have a 401(k) plan built upon outdated legacy platforms that only accommodate mutual funds. As a result, the widespread usage of target date retirement ETFs will be limited for now.
In the end, target date retirement funds are not a panacea. While they have some benefits, they still have many flaws. Their recent performance during extreme market conditions is shaky, one size does not fit all and excessive fees hurt investors.
In the end, a customized investment plan that’s tailored to suit an individual’s unique investment goals should probably be most people’s first choice instead of a mass produced investment solution that solves other people’s problems.
This article is brought to you by ETFguide.com, and written by its editor Ron DeLegge. ETFguide is the information leader on exchange-traded funds because of its vendor-neutral approach and its progressive reporting style. Unique features include an ETF bookstore, a monthly e-mail newsletter, and subscription based ETF portfolios.