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.”