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February 12, 2014 at 10:21 AM
Target date funds have become the investment of choice for investors saving for retirement through 401(k) plans. Usage of these funds grew rapidly after passage of the Pension Protection Act of 2006. The PPA permitted employers to automatically enroll new employees in 401(k) plans and established target date funds as qualified default investment alternatives (known as QDIAs) for these plans.
We consider target date funds to be a superior solution to the default investment option previously in place for most 401(k) plans, which was to use a money market fund. However, target funds have shortcomings that investors should consider, and may not be appropriate for all investors.
The limits of a mass market approach to asset allocation
Although asset allocation funds are reasonable solutions for investors who don’t seek personalized advice, each individual investor is different and ideally should develop a personalized investment plan. Target date funds, as mass market products, are designed to create a uniform experience for all investors in the fund. Investors in each target date fund, however, may have dramatically different financial considerations, including level of savings, expected income in retirement, expected expenses in retirement and life expectancy.
See related: Beware of target-date funds
The “one size fits all” approach to asset allocation may create a substantial mismatch between the positioning of the fund and the ideal positioning given the individual investor’s personal circumstances. We are proponents for a comprehensive planning approach that identifies investor resources including assets, liabilities and projected savings, matched against the future goals and resources that the goals will require. We think that the comprehensive planning approach, built around goals and risk capacity, provides the model for an investment plan more likely to help investors reach their retirement objectives.
The impact of rising rates
Most analysts expect interest rates to rise over the next few years, though there is spirited debate about the outlook for rates in 2014. Regardless, most analysts agree that the 30-year-long bull market in bonds is over and that the Fed will begin to normalize monetary policy.
Target date funds have a predetermined glide path that defines how the asset allocation will change over the lifespan of the fund. The glide path for each fund is a key disclosure item for the fund, and is typically only changed with significant effort from the fund company. Some advisors may consider an inflexible glide path to be a negative feature of the target date structure.
The allocation to fixed income may be considered another negative for target date funds. Most target date funds were created during the height of the bull market in bonds, establishing glide paths using data from a period in which bonds served as both a source of income and a risk counterweight to equities. As a result, the typical target fund relies heavily on fixed income in and near retirement.
See also: Why ‘one portfolio’ is the top choice for 401(k) investors
For example, large target date funds such as Vanguard, T. Rowe Price and Fidelity have more than 50% of their 2010 Fund in cash and fixed income. Figure 1 shows, in red, the equity exposure at Fidelity declining throughout the glide path. The remainder of the portfolio is in fixed income and cash. The 2010 fund is 49% equity and therefore 51% cash and fixed income; that changes through retirement to 20% equity and 80% fixed income and cash.
This can be a negative because in a rising interest rate environment, the bonds may not provide the expected return and may add to risk rather than reduce it. A bear market for bonds may disproportionately harm investors in or near retirement. Figure 2 illustrates the harm that can be caused by a high fixed income allocation. The chart shows performance during the height of the market turmoil and spike in yields of mid-2013. Far from providing protection in a down market, the average fund with a target date in the 2000 to 2010 range—for current retirees—had a loss of 5%.
