Navigating the Flaws of Target Date Funds

Target date retirement funds are under a great deal of scrutiny, and were recently the subject of Senate hearings, simultaneously represent the best and worst that the mutual fund industry has to offer. "Best" in the form of an innovation that could improve the returns earned by millions of indifferent retirement savers; "worst" in the form of the industry's clumsy and self-interested way of offering these funds to investors.

In the abstract, target date funds are a worthy addition to the industry's suite of alternatives. The funds invest in a mix of stocks and bonds, a mix that automatically becomes more conservative as its investors approach retirement. (In industry jargon, this shifting of the fund's allocation over time is called its "glide path.") This autopilot method of investing -- which takes the crucial asset allocation decision out of investors' hands -- has the potential to be a vast improvement over the approach used by millions of investors saving for retirement, who invest either too conservatively or too aggressively.

Target date funds received a strong endorsement from the Department of Labor in 2007, which ruled that employers could use them as the default savings vehicle for retirement plan participants. Prior to this ruling, the assets of workers who were automatically enrolled in their employer's retirement plan were typically invested in money market funds, which are a fine choice for short-term savings, but a terrible option if one is saving for a far-off goal such as retirement.

With the Department of Labor's endorsement, employers rushed to add target date funds to their plans. In a recent interview in Barron's, Fidelity's Derek Young said that fully 65 percent of the retirement plans they administer use target date funds as default investments.

But on the heels of the 57 percent market decline, many investors discovered -- too late -- that all target date funds are not created equal.

Here are some of the flaws with these funds that have come to light:

• The difference between "to" and "through." Most target date funds have a year in their name that corresponds to an expected retirement date. (A 35 year-old worker, for instance, would be placed in a 2040 target date fund, because that year is close to their expected retirement date.) Many investors in these funds believed they were investing "to" this retirement date, whereupon they would take their money out. Most fund managers, on the other hand, operate these funds under the assumption that the investors' money in these funds will need to last (and thus remain invested) "through" retirement -- a period of 20 or 30 years in many cases. This difference in time horizon goes a long way toward explaining why many investors approaching retirement were shocked to see that their target date fund had fallen by 20 or 30 percent this past winter. If you're two years from withdrawing your money, a 50 percent stock allocation, for example, is quite aggressive; but if you're relying on your nest egg to sustain you throughout a 30 year retirement, that same stock allocation is much more defensible. This confusion highlights the fact that education and communication about the goals of these funds has been, at best, inadequate.
• Differences in allocations. The above confusion aside, there is a wide disparity between the asset allocations of target date funds. Consider the data in the chart below, which depicts the equity holdings of 2010 target date funds. The spread, from a low of 11 percent to a high of 67 percent, underlies the wide gulf between the performance of these funds. The most aggressive fund lost 41 percent in 2008 -- surely enough to put a dent in any near-retiree's plans -- while the most conservative fund lost only 4 percent. What explains these huge differences in allocation? It's impossible to say for certain, but one possibility that Morningstar's John Rekenthaler offered in his Senate testimony is that if a manager is trying to attract assets to his fund, one of the best ways to do so is through above-average performance. And if their fund holds, say, 60 percent in stocks while their competitors hold an average of 40 percent, their fund's return will look that much better if the stock market cooperates. More cynically, the fact that managers tend to get paid more to manage stocks than they do to manage bonds means that they also have a financial incentive to adopt a more aggressive allocation. Whatever the reason, the end result is that investors with similar goals have achieved highly disparate results from products they would have reasonably assumed to be very much alike. This experience suggests the need for industry standards on asset allocation ranges in these funds.

• Outsized expenses. The final difference will not surprise anyone remotely familiar with the mutual fund industry: they tend to be far too expensive. Most target date funds are "funds of funds," which means that the funds themselves have no true manager; their assets are simply invested in a handful of the firm's other mutual funds. There's no additional layer of value added in target date funds, and the manager is being compensated for their services via the expenses charged in the underlying funds. But this doesn't stop most managers from double-dipping. According to Lipper, an amazing 908 of 992 target date funds levy an additional fee on their target date funds, over and above the fees charged by the funds it invests in. Even worse, an analysis by BrightScope of target date funds in retirement plans found that these funds were 10 to 25 percent more expensive than the other core funds that were offered in retirement plans. Assuming that the Department of Labor wasn't interested in finding a way to increase mutual fund managers' revenue, they might want to consider amending their endorsement of these funds, dictating that only target date funds that limit their expenses to those charged by the underlying funds can be used as default investments in retirement plans.

Until then, investors are on their own. So if you're considering a target date fund, focus first on its expense ratio. If it is higher than the expense ratios charged by the other core funds in your retirement plan, you'll be better off creating your own asset allocation, and adjusting it moderately through the years. Towards that end, pay close attention to the asset allocation of the target date funds you have available. Don't choose one solely because the year in its name is close to your retirement date; make sure that you're comfortable with the risks it will be assuming.