What’s Lurking Behind Your Target-Date Fund?

by Will Ashworth | June 13, 2012 10:02 am

Does your 401(k) plan offer target-date funds? Some 70% do.

According to the Investment Companies Institute, 401(k) participants in their 20s were more likely than other age groups to own them. Approximately 27% of their 401(k) assets are invested in target-date funds — a major reason for the funds’ significant growth.

At the end of 2010, target-date funds accounted for 11% of all 401(k) assets, up from 5% at the end of 2006. While they serve a purpose, I’m afraid many of those twentysomethings understand very little about how they work and what they cost to own. No one should purchase any investment without first answering these two important questions.

Target-date funds generally provide investors with three things: prepackaged, all-in-one portfolios; portfolio allocation based on one’s expected retirement age; and an age-based rebalancing service where one’s exposure to risk is reduced over time. That’s why you tend to see fund names like Target Date 2035, etc. It’s a beautiful concept, and when done correctly, makes an awful lot of sense.

However, this doesn’t mean you can sit back and relax. That’s because the funds use what’s called a glide path — the extent to which allocations change for different age groups over time. This means that if you’re 30 and your wife is 25, the allocation of stocks and bonds in your fund will be different than the same fund’s allocation when your wife is 30.

Experts at Morningstar Ibbotson Associates have named the rate of change that occurs in the glide path over time the Glide Path Stability Score[1], or GPSS. These scores matter because the same 20-year-olds mentioned earlier could be looking at a target-date fund in 30 years that’s nothing like the one they purchased when they were in their 20s. That’s not necessarily a bad thing, but if changes in allocation are severe and aren’t properly communicated to investors when they are made, many investors could be in for a shock at some point closer to their intended retirement.

Let’s look at two fund families: the T. Rowe Price Retirement Funds, which have a low GPSS, and the ING Solution Portfolios, which have a high one.

Using a person aged 25, let’s compare similar offering from both fund families. I’m going to assume that the retirement age of today’s 25-year-olds will be greater than 65. Therefore, I’ll use each company’s 2055 retirement fund (for retirement at 68) to compare fees, allocation, etc.

Morningstar Ibbotson gives T. Rowe Price a GPSS since inception of 1.02%, which means its equity exposure has changed by a little over a percent annually, while the ING Solution Portfolios have changed by more than 6% annually. How many ING fund holders do you think are aware of this glide path change, and more importantly, actually understand it? Evidence suggests the answer is very few.

Several things jump out at me about the differences between these two funds. First, the management expense ratio for the T. Rowe Price fund is 0.76%, versus 0.93% for the ING fund. Second, the turnover for the T. Rowe Price fund is 27.4%, about one-third that of the ING Fund. Generally, the more a fund buys and sells stocks, the higher the fees.

Lastly, the T. Rowe  Price fund has 10% bonds and 90% equities, compared with about 6% bonds and 94% equities for the  ING Fund. It’s possible, given the higher annual glide path changes for the ING fund, that they started out with a similar bond/equity allocations. According to Morningstar, ING’s target-date funds have the some of the highest exposures to equities for retirement dates further out, such as 2055. This is something to be aware of.

In and of itself, changes in the glide path don’t necessarily mean the fund’s a dud. But it does mean that investors should understand why the managers made these changes to the portfolio’s composition. If you’re unable to make heads or tails of this, it’s best to seek alternatives that are more candid and explanatory about their portfolio management.

A study of 401(k) retirement plans by the Pension Research Council at the Wharton Business School has this to say about target-date funds: “The predicted adoption rate from new-hire automatic enrollment into a target-date fund was 57 percent, almost twice as large as the organic adoption rate of 31 percent among new entrants voluntarily electing target-date funds.”

Translation: Twentysomethings, who represent a significant portion of new hires in our workforce, are the most susceptible to the vagaries of glide path changes. So don’t assume your 401(k)’s inclusion of target-date funds is a good thing until you’ve done the requisite homework. They’re not always what they seem.

As of this writing, Will Ashworth did not own a position in any of the stocks named here. 

  1. Glide Path Stability Score: http://finance.yahoo.com/news/target-date-funds-glide-path-110000144.html

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