Are Target-Date Funds A Good Way To Invest?

Are Target-Date Funds A Good Way To Invest?

The percentage of 401(k) plans that offer target-date funds increased from 57% in 2006 to about 75% last year, with 39% of participants actively invested in the funds, according to a study by the Employee Benefit Research Institute and the Investment Company Institute.

A target-date fund is a fund of funds that assumes you will retire in a certain year, and adjusts its asset allocation model as it gets closer to that year.  If you plan to retire around 2030, for example, you would pick a fund with 2030 in its name.  The fund’s glide path determines how the asset mix changes as the target-date approaches.  Some have a very steep trajectory, becoming dramatically more conservative just a few years before the target date.  Others will take a more gradual approach.  The asset mix at the target date can be quite different as well.  Some target-date funds assume that the investor will want a high degree of safety and liquidity, while others assume that the investor will hold onto the funds past retirement, and will therefore include more equities in the asset mix, reflecting a longer time horizon.

The Good

Jane Bryant Quinn of MoneyWatch believes target-date funds are good for investors who are young.  During those years, one size generally fits all.  She feels most 30-year-olds should invest primarily in stock-owning mutual funds, and most 40-year-olds can afford to be 70 percent in stocks.  That’s typical of what a sensible target-date fund will do.  Craig Israelsen, a professor of personal and family finance at Brigham Young University, agrees.  “From a financial point of view, all 25-year-olds are pretty much alike,” he says.

In fact, many financial planners who believe in passive investing also follow a similar strategy of allocating a certain percentage of a client’s funds to a number of different asset classes, rebalancing periodically, and changing the allocations over time to reflect the client’s eventual shift from growth to asset preservation.

The Bad

However, not all target-date funds are created equal.  First, glide paths can be very different, as indicated above.  Second, some invest in only a few asset classes (e.g. US stocks and US aggregate bonds), while others spread their investments across a more diversified set of asset classes (e.g. foreign stocks, muni bonds, etc.).  All these differences make it difficult for a retail investor to determine whether or not the specific target-date funds offered in his or her 401(k) or 529 plans are appropriate for his or her situation.  As if that weren’t challenging enough, many target-date funds do not disclose their allocation models and glide paths, making the decision that much more difficult.

The Ugly

As investors approach retirement, the asset allocation they need tends to become much more personalized to their specific situation.  If the balance in the investor’s account isn’t enough to meet his or her retirement needs, for example, a fund that moves to a more conservative asset allocation may have no hope of providing the type of investment returns that will be required to keep those retirement plans on track.  According to Quinn, “After age 55 or 60, you can’t automatically rely on target-date formulas any more.  How you deploy your money depends on many more things than your age.  You have to consider your health, employment prospects, how much money you’ve saved already, your retirement expenses, and how you want to live.”

Another challenge with target-date funds is their volatility, which is a function of their asset allocation at any given time.  After the market crash in 2008, many investors were shocked to discover a quarter or more of their savings had disappeared from target-date funds they mistakenly thought were safe.

So what is an investor to do about these funds?  If you’ve invested money into a 529 plan for your child or a 401(k) plan at work that offers target-date funds, and you do not have a financial planner to advise you or the inclination to learn about modern portfolio theory and asset allocation models on your own, the target-date fund choice might be your best option.  Even better, Morningstar now rates target-date funds, so you can go to their website (morningstar.com) to find out more about the choices you have and whether or not they are worth investing in.

One Response

  1. Ronald Surz says:

    The benefits of target date funds are diversification and risk control (professional management), preferably at a reasonable cost, all of which a participant is unlikely to achieve on his or her own. Nevertheless, all benefits could be a lot better.

    • Diversification is inadequate because most TDFs are predominately US stocks and bonds. Some TDFs have recently touted reduced fees, but be careful. Low fees equate to low diversification since diversifying assets command a high price, namely commodities, real estate, natural resources, foreign stocks and bonds, etc.

    • Similarly, TDFs are too risky. We learned this lesson in 2008 when the typical 2010 fund lost 25%. Nothing has changed since so the vulnerable remain exposed to large losses as they near retirement, which is shocking.

    Pensions & Investments published my article on this topic in March, 2008: ‘The good, bad & ugly of target date funds.”

    A patent for my glide path design — the Safe Landing Glide Path — is scheduled to be awarded on 1/8/2013.

Leave a Reply to Ronald Surz Cancel reply

Your email address will not be published.

This site uses Akismet to reduce spam. Learn how your comment data is processed.