Can Target Date Funds Miss the Mark?

in Retirement Planning by

It is easy to see the appeal of Target Date Funds. Savers can plop their money into one fund – usually a diversified mix of stocks, bonds and other assets – and as their pre-picked date of retirement nears, the fund ratios automatically reset to a more conservative asset mix to presumably shield them from risk.

This notion of “set it and forget it” burst onto the retirement stage after new rules were enacted by Congress in 2006 which encouraged employers to improve 401K offerings. Target Date Funds have proven widely popular among retirement savers who like the convenience of not having to be hands-on with their portfolios and fear they would be unable to effectively manage their own retirement needs.

According to the Investment Company Institute, the assets of Target Date Funds have grown from $71 billion in 2007 to $540 billion as of the second quarter of 2013.

But is easy always better? At Personal Capital, we’re skeptical of the set-it-and-forget-it and one-size fits all approaches. Here are some of the limitations of Target Date Funds that every investor needs to consider:

1. One-Size-Fits-All Might Not Fit You.

The reality is that the typical Target Date Fund looks at only one criterion: when you plan to retire.  It does not take into account individual circumstances including personal risk tolerance, current wealth, other assets, current income and even expected income in retirement.

Let’s take a look at a simple example to illustrate this point.  Say you are 65 years-old and beginning retirement next year.  You have a 2015 Target Date Fund that assessed your allocation appropriately for your situation, setting bonds at 50%.   In addition, let’s say you’re expecting to get 50% of your income from social security.  As John Bogle, the founder of the Vanguard Group, articulated at a recent Morningstar Conference in a critique of Target Date Funds: because social security is like a bond, your exposure to that asset class would effectively be much higher than the intended 50%.  It’d be more like 75%. An overly conservative portfolio might mean you are inadvertently limiting your potential returns.

While the assumption that savers should move to a safer, less volatile strategy as they near retirement is generally valid, it can’t be the only tenet guiding an investment strategy.  Everyone’s financial picture is unique.

2. Do You Really Know What’s in Your Target Date Fund?

“People pick target date funds because they  are easy to use, but most don’t really know what’s inside,” says Craig Birk, Vice President of Portfolio Management for Personal Capital.

With Target Date Funds, the details can be in the fine print –  or sometimes, not available at all.  A recent investigation into the transparency of target date funds found that most target date funds in 401ks are “fund-of-funds,” and do not actually report the underlying securities.  That makes it even harder to know what you’re actually investing in.

It’s true that with 401k funds, as an employee, you often have little choice in what is available to you.  Target Date Funds are particularly popular in 401ks;  Vanguard, which manages nearly $500 billion of the $4 trillion in US 401k plan assets reported in a study of its clients’ investment patterns that over 25% of its clients had their entire 401ks invested in a single target date fund. But you can – and should – do some research to find out what is inside your fund and its allocations.  Otherwise, it will be difficult to tell if your investment strategy is actually appropriate for you.

That’s partly why we designed the Personal Capital “Asset Allocation” tool – and our Investment Checkup.  With these tools, our users can see the true asset allocation in any fund they’re in, and whether their investment strategy is appropriate for their needs.  “Know what you own,” says Craig.

3. What About Those Fees?

We’ve written at length about excessive mutual fund fees (see this article on The Seven Deadly Investor Sins).  Target Date Funds are on average more expensive than mutual funds.

According to Morningstar’s Target Date 2013 survey, the “weighted-asset” average fee for Target date funds was 0.91% in 2012, versus 0.77% for mutual funds (the simple average for mutual funds is 1.4%).  If that fund is in a 401k plan, there are probably other administrative fees that you’re paying on top of that.  And that can end up costing you in retirement.  For example, a $1,000 per year investment over 45 years with a 7% return will be $285,749. But at a 6% return, it will drop over 25% to $212,744.

Even within Target Date Funds, the fees can vary widely so it is important to find out what fees are associated with your plan.  Because it can be hard to track down the fees that you pay, the Personal Capital Investment Checkup tool was designed to bring transparency to those, too.

The Bottom Line.

Target Date Funds are certainly a step in the right direction, creating diversified portfolios for investors that rebalance to become more conservative over time.  But you might be able to do better, especially if you can find a financial tool or an advisor who can customize your strategy to meet your goals.  “You can usually create a better portfolio on your own,” says Craig.

So what should you do?  Take a look at what’s in your Target Date Funds to make sure they work for you in the context of the rest of your financial picture.  For your 401ks, we realize you may have little choice.  So as a perk for Personal Capital investment clients, we’ll advise on your 401k as part of our wealth management offering – for free.  Schedule an appointment to discuss your options with one of our financial advisors.

Try Our Investment Checkup Here

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One Response

  1. Ralph

    Bogle has a good point that pensions, Social Security are like bonds. It seems to me that Target Date Funds intend to risk manage for you but they don’t really know your schedule. Can I put 5 years of money in a 2015 fund and then put 5 more years of money in a 2020 fund and so on which may appear to be a good Idea but is probably stupid concept when you learn how they diversify the target date fund. I like the “bucket” approach. Here you decide when you need the money and how much risk you are willing to accept and you invest appropriately. Mostly the ‘when’ is what target date funds manage but without regard to your personal goals and real future needs. So I set up stages of funding needs like emergency money, next year or two, 3 to 5 years out. coupled with risk rules like don’t invest anything in the market that I will need in 5 years. Longer if you are risk adverse. No one really talks about the real risk of certain types of investing in a conversation that covers most investments. Even Morningstar’s risk assessments are relative to the comparable type of investment which makes it hard to understand what your real risk are. For instance, I owned a lower end investment grade bond that lost its investment grade rating. The value dropped 20%. It was a good thing that I was bond laddering and intend to hold to maturity (at least I hope). What are the risk of a specific bond failing to payoff at maturity? How do you compare risk in a bond, a preferred stock fund like PFF or an ETF. If you buy a bond fund and interest rates rise your screwed. Which gets back to one of the benefits of a Target Date Fund is that it gets large enough and diversified enough so that the risk of a bond or company is minimized.

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