With over $270 billion in assets target-date funds continue to be the most popular investment choice in 401(k) plans.

Since the U.S. Department of Labor endorsed target funds in the Pension Protection Act of 2006 as “qualified default investment alternatives” for all 401(k) plans target-date funds, (TDFs) have enjoyed an informal Good Housekeeping Seal of Approval in many plans.  Whether this is earned or not, projections from Cerulli Associates show that by 2012, the amount invested in TDFs is expected to swell to $1.1 trillion.

So with so many 401(k) participants and other investors choosing TDFs, how have these funds fared during the recent turbulent bear market?

The answer depends on the time period.

Take the 2008 market decline.  According to researcher Craig L. Israelsen, “shareholders were in for a big shock” when the four largest TDFs in the 2010 category lost on average 13.7% year- to-date through Sept. 30, 2008.   

Writing in Financial Planning magazine, Israelsen said “Consider what a loss of that type of magnitude translates into for a 63-year-old baby boomer who has a $500,000 account balance in the “average” 2010 fund on Jan. 1, 2008. By Sept. 30, the account value in his or her fund had dropped by $68,500.”

The losses among TDFs in the 2008 period were so severe that Forbes’ ran an article in November 2008, “Targeting the Poorhouse,” which noted that 10 of the largest TDFs in the 2010 category lost “at least 30% of their value” so far that year:

Thankfully for shareholders, recent performance has improved significantly.  According to Morningstar data, the most recent one-year performance of the top 10 TDF families averaged 15.64% (on an asset-weighted basis), while the year-to-date performance (through Oct. 31, 2010) averaged 8.71% for this same group.

Another source of good news is that Morningstar data found that the average expense ratio of TDFs declined to 0.88% from 0.91% a year earlier for funds that are at least 18 months old.

Sources of the Problems

While TDFs remain the favored default investment in 401(k) plans, fund providers are still refining their offerings.  At issue are asset allocations, risk exposures and what happens to the fund once the retirement date is reached.  Overall, these exposures and policies are called the fund’s “glide path” and each fund company has a different asset allocation approach.

As a target-date fund marketer for three separate fund companies, I saw how these issues were handled when TDFs were introduced.  As some fund companies scrambled to introduce them, they were often launched without a fully-developed strategy.  For example, when I interviewed the lead TDF manager of one fund family and asked what would happen when the actual retirement date was reached, he paused a few seconds and said “that was still a work in progress.”  He did not specify how the money would be invested at the retirement date.

Today, each fund family employs a different investment strategy once the retirement date is reached.  Since these funds to not cease trading, some funds may continue to offer their same asset mix, while others may increase their fixed income exposures.  Investors have to specifically ask what happens in their fund when the retirement date is reached.

While behavioral evidence finds that most participants withdraw their money at, or shortly after, the target date, some managers insist they must maintain high equity exposures, accompanied by high risk.  The reason: some managers believe their mandate is to manage the assets until a participants’ death, rather than just to their retirement date.

Nagging Issues Remain

While this may seem like an honest difference of opinion, some experts disagree.  According to Joe C. Nagengast of Target Date Analytics, “target date fund managers should stick to their core mandate, prudently managing participant assets during the accumulation phase, and give up the unsupportable claim that they must manage to participant death.  That claim is becoming increasingly transparent as a thinly disguised justification for trying to hold on to participant assets.”

Nagengast also said TDF managers have “high-jacked participant’s accounts” by not reducing equity exposures and risk as the target date approaches.  In effect, the TDF managers are doing a “bait-and-switch” because the fund is being sold as an increasingly conservative portfolio as the retirement date approaches, but then the risk is increased as the managers unilaterally pursue longevity risk.

“All they really do is add market risk to longevity risk. Participants (especially those hoping to retire in 2008 and 2009) were badly burned by this strategy. The managers forsook principle

preservation at the target date in favor of a simplistic, long-term, risky portfolio strategy,” according to Nagengast.

Aside from differences in asset allocations and risk exposures, TDF managers have a special role since they now manage the “qualified default investment alternative” as specified in the Pension Protection Act of 2006.  As a result, TDF managers should now assume special responsibilities.

Nagengast said he is “in favor of requiring mutual fund managers, like other managers of qualified default investment alternatives, to serve as ERISA fiduciaries, by pointing out that the allocation and glide path decisions have even more impact on the outcome than on the selection of the underlying funds.”

Another caveat for investors is that all of the TDF’s named here are comprised of their own funds.  This means that all the underlying funds in any TDF cited here are all managed from the same fund family. 

This is why some critics have said TDFs are more of a packaging coup than an investment innovation.  When you invest in a TDF, you are buying into each of the underlying funds, regardless of their performance. The fund company benefits since they are directing new assets into a fund which normally would not be attractive to investors on an individual basis. This is one reason for performance shortfalls.