Mutual funds with a projected retirement date attached have been lauded by some within the mutual fund industry as the be-all and cure-all for retirement savers. But are they?
Despite their growing popularity, target date retirement funds have some very big problems. Do their problems outweigh their benefits? Let’s analyze this question.
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 10 years or more will typically hold a greater portion of the portfolio in growth investments, like stocks, whereas funds with a time horizon of less than 10 years 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 10 years might select a retirement fund with the year 2020 as its target date.
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” or “QDIAs” for short. This labeling also provides liability protection for employers who sponsor a 401(k) plan that use target date funds as a default investment option for employee participants.
“The Pension Protection Act accelerated the growth of target date funds but it didn’t cause it,” said Fred Reish, chair of the Employee Benefits Practice at Reish & Reicher in Los Angeles. He observes that asset growth within target date funds was already well along.
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.
“I like the idea of target date funds but I don’t like the execution,” said Roger Wohlner, CFP with Asset Strategy Consultants in Arlington Heights, Ill. “The biggest problem with target date funds is the fact that there is still a great deal of confusion and misunderstanding among both participants and plan sponsors.”
Wohlner says the variation in equity percentage among even short-dated funds with the same target date is quite different across the 40 or so fund families offering target date funds. These discrepancies were magnified in 2008 when many 2010 funds suffered losses in excess of 20 percent.
“People think target date funds are more conservative shortly before retirement than they really are,” said Reish. “As a result, people can suffer tremendous losses right before retirement.”
The Securities and Exchange Commission noted similar issues in a summary of proposed rules governing how target date funds are marketed and sold.
“Although the 2009 returns were positive, the differences between 2008 and 2009 returns demonstrate significant volatility,” noted the agency. “In addition, 2009 returns, like 2008 returns, reflect significant variability among funds with the same target date.”
Another problem isn’t so much with target date funds themselves as with the implicit faith placed in them by 401(k) sponsors. The fact is many employers may conduct a certain degree of due diligence among the open funds offered, but they often tend to take the target date funds on faith. This is especially true if the 401(k) plan is via one of the fund company platforms that offer a family of target date funds.
In Wohlner’s view, the whole “truth in labeling” thing is a key issue. He’s in the process of starting a separate advisory firm to offer direct investment and retirement planning advice to plan participants because he sees a need for an alternative to target date funds.
“Selecting target-date funds does not relieve fiduciaries from the responsibility of evaluating the quality of target-date funds and their performance,” stated Darwin Abrahamson, CEO of Invest n Retire in a white paper titled “Target-Date Funds Risky for Plan Fiduciaries.” He argues a 3(38) investment manager is a more prudent choice than target date funds for 401(k) plans.
A 3(38) investment manager is “open-architecture” and differs from target date funds in two important ways — the asset allocation models can be designed to match the specific objectives and demographics of the plan, and sponsors are free to select their preferred investment manager.
However, using a target date fund as the plan default presents significant liability risks that are not present with asset allocation models.
One such risk is that the 401(k) plan has no ability to alter the asset mix or replace an underlying component manager, even if it would be prudent to do so. “While the plan could always replace the entire target date fund structure, such a change is reactive, time-consuming and expensive — and if the plan adopted a different single-manager target-date fund structure, it could find itself facing the same decisions again in the future,” stated Abrahamson.
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.
Another major obstacle for target date funds are high costs. The average annual expense ratio for target date funds is close to 1.25 percent, making them likely to underperform against a lower cost portfolio containing stock and bond index funds over the long run. Target date ETFs, however, have made strides toward greatly reducing investor’s costs. BlackRock 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 (TZD) to 2040 (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 is still limited.
In the end, target date retirement funds are not a panacea and while they have some benefits, they still have many flaws. Their recent performance during extreme market conditions is mixed; one size does not fit all and excessive fees hurt performance. Regardless, some financial advisors still think the benefits of target date funds outweigh the negatives.
In contrast, other advisors question the ultimate value of target date funds, particularly their ability to execute on their promise. They perceive that target date funds will never be able to build a customized investment portfolio that’s tailored to an individual’s unique investment goals.