Last Updated May 27, 2010 10:07 AM EDT
Many 401(k) plans offer a lineup of target date funds, and I've written previous about how to choose a fund from such a lineup. In this case, your plan sponsor often has the clout to negotiate favorable terms on your behalf, selecting funds with reduced expenses that are available just to 401(k) plan sponsors. (For more details, see the links at the bottom of this post.)
But what if you're going to the financial institution on your own, say for your IRA or other personal retirement savings, and have the opportunity to choose among many target date funds offered by different financial institutions? In this case, you'll need to pay close attention to the names and descriptions of the funds, as you'll soon see.
This subject has enough moving parts that I'll need two posts to fully address the issue, so here I'll cover important background and talk about performance of target date funds. Tune in tomorrow for Part 2, where I'll talk about expenses and summarize my recommendations.
Many target date funds are a "fund of funds" where the financial institution uses its funds for the underlying components of the target date fund. In a few cases, the target fund has its own portfolio of stocks, bonds, and cash; examples include the family of Wells Fargo Advantage funds.
Most of the mutual fund families have several versions of a specific target date fund, depending on whether you buy the fund through an advisor or on your own. There can be versions with and without front-end or back-end loads, and versions with different expense loads. These funds usually have the same name and target retirement date, but with different letters after the name, such as A, B, or C, or R1, R2, R3, that refer to the different classes of each fund. This naming convention presents the potential for confusing investors, so you need to make sure you do your homework carefully when you're investigating these funds.
For the purpose of this post, I'll concentrate on funds with a 2020 retirement date. Here are three other criteria I also considered for my analysis:
- The funds must have at least a three-year track record, since I'm not comfortable using a fund that hasn't been around for at least that long. If I required a longer track record, I'd eliminate some good offerings, since many target date funds haven't been around that long.
- I've just considered funds that have at least $100 million in assets. My thinking is that if I'm investing in a fund for a long period -- throughout my retirement -- I want to have assurance that it will be there down the road.
- I didn't include funds that are available only to institutional investors, such as 401(k) plans.
How Did They Perform?
I looked at the net returns as reported by Morningstar for the past three years -- from May 19, 2007 to May 20, 2010. This period spans both our economic meltdown and the start of our recovery, and now the most recent downturn. Target date funds are "buy and hold" funds, meaning they intend for you to hold them for a long period throughout a large portion of your retirement. So it's inevitable that you're going to see both more good times and more bad times while you are invested in these funds. For this reason, it's my opinion that the net performance over the past three years is an appropriate yardstick for target date funds.
Another reason to look at performance during the past three years comes from recent findings in behavioral finance. These findings show that most investors value protection during a downturn more than squeezing the highest return during an upturn. I believe this motivation is even more important to investors in target date funds for their retirement.
The returns during this period will be significantly influenced by a fund's asset allocation, the fund managers' ability to select securities that perform well, and the fund's underlying expenses. With that said, the top five performing 2020 target date funds during the last three years that meet the criteria described above, along with each fund's return over these three years, are as follows:
- Wells Fargo Advantage Inv (WFDTX): -1.55 percent
- Russell LifePoints R1 (RLLRX): -2.28
- MFS Lifetime A (MFLAX): -2.91
- Vanguard Target Retirement (VTMNX): -2.97
- JP Morgan SmartRetirement A (JTTAX): -3.11
- Alliance Bernstein Ret Strategy B (LTHBX): -9.15 percent
- DWS LifeCompass B (SUPBX): -7.38
- Principal Financial Lifetime R2 (PTBNX): -6.20
- Fidelity Advisor Freedom (FDAFX): -5.99
- Schwab Target (SWCRX): -5.45
- Target date funds have significant exposure to stocks and will inevitably lose money during downturns. Some investors were surprised when their target date funds lost money during the meltdown, but if they were aware of the fund's asset allocation, they shouldn't have been.
- Asset allocation can protect you against severe losses. While nobody likes to lose money, losing just a few percentage points during the past three years isn't devastating compared to the losses you would have experienced if you had been fully invested in the stock market.
While performance is important to analyze, there are other aspects of target date funds to consider, such as the level of expenses, and whether or not you're paying a front-end or back-end load.