2015-08-14 09:00:00 Financial Management English Target Date Funds, also known as TDFs, offer less risk as you get closer to retirement. Learn how these funds work and the pros and cons of... https://d2yxjugd6jl4bj.cloudfront.net/wp-content/uploads/2015/08/08232958/2015_7_16-medium-am-pros_and_cons_of_using_target_date_funds_in_your_401k.png Pros and Cons of Using Target Date Funds in Your 401(k)

Pros and Cons of Using Target Date Funds in Your 401(k)

7 min read

With over $741 billion in assets (as of March 31, 2015), target-date funds (TDFs) are the most popular investment choice in 401(k) plans and IRAs, according to the Investment Company Institute. But what exactly are TDFs, and why have they become so popular? An equally important question is, “are TDFs the best investment choice to include in your 401(k)?”

target_date_funds__2014.jpg

TDFs are mutual funds comprised of other stock and fixed-income mutual funds. They are designed to meet long-term investment goals. TDFs themselves are comprised of a mix of asset classes (e.g. stocks, bonds, commodities) and equity styles (value, growth) that the fund manager adjusts to become more conservative over time.

An investor should use a TDF if he or she wants three things:

  1. To hold a mix of asset classes
  2. Would like his or her portfolio to be professionally-managed
  3. Expects automatic adjustments to become more conservative as he or she reaches retirement age and beyond

While investors should choose a TDF date that matches the investor’s appropriate retirement date, the fund can be held well beyond that actual date.

TDFs have some unique benefits that often cannot be achieved by individual investors unless they have special skills or are prepared to devote the time to manage their portfolio. These benefits include:

  • Broad diversification across asset classes;
  • Preventing an overexposure to certain asset classes, which may increase risk;
  • Automatic rebalancing back to the target allocations; and
  • Rebalancing the portfolio over time as the investor approaches retirement age, prompting a move towards a more conservative portfolio.

What makes TDFs unique is their built-in portfolio mix, known as the “glide path,” that becomes more conservative by adjusting the bond-to-equity portfolio mix as the retirement date approaches. Glide paths are a key differentiating feature in all TDF fund families, and vary according to risk levels chosen by fund managers.

target_date_fund_glide_path_chart.jpg

Anyone investing in a TDF should choose a fund based on this glide path and its asset allocation and risk levels. If an investor has a higher risk tolerance and wants greater equity-to-bond exposures in the TDF, however, they can choose a fund that has a longer retirement date. In this case, the longer retirement date TDF (i.e. 2025 versus 2020) has a greater exposure to equities and high risk, accompanied by the possibility of generating higher returns.

Why TDFs Became Popular

Since the U.S. Department of Labor (DOL) endorsed TDFs in the Pension Protection Act of 2006 as “qualified default investment alternatives” for all 401(k) plans, TDFs have become exceptionally popular in many 401(k) plans. The DOL made this decision because too many 401(k) participants failed to specify an assortment of funds of their own choosing. The DOL’s decision has proved effective, as the amount invested in TDFs is expected to reach $1.1 trillion by 2016, according to Cerulli Associates.

According to a study released by Brightscope/Target Date Analytics, TDFs account for 10% of total invested assets in retirement plans. This number is expected to exceed 28% by 2020. In the 401(k) space, Vanguard Funds reported that 79% of the 401(k) plans it administers offered TDFs last year; an increase of 13% from 2004. Vanguard also said that 31% of its Vanguard plan participants were invested in a single TDF in 2013, which has more than doubled over the past five years. Among new plan entrants, two-thirds of participants were invested in a single TDF.

TDFs are usually offered in five- or ten-year increments. For example, if a person plans to retire in 2019, they can choose a TDF with a 2020 date. In another example, a person retiring in 2023 can split their contributions and choose to invest in both a 2020 and a 2025 TDF.

But reaching the retirement date does not mean investors should exit their TDF. On the contrary, longevity statistics indicate that most people who make it to retirement will need to make that accumulated wealth last at least another 20 or 30 years. This means they can continue to use the TDF to earn money.

The main attraction of TDFs is the built-in portfolio diversification, and not necessarily their performance. The reasons for the performance lags are due to variations in asset allocation, costs of active management and other fees.

Of these reasons for performance lags, the importance of diversification cannot be understated. That is because numerous academic studies have found that asset allocation is responsible for more than 90% of a portfolio’s performance variability over time.

Ranking TDFs is difficult by design, since the funds have varying asset mixes and asset classes, depending on how far they go into the future. The funds which carry the most risk are those which extend furthest into the future. In some cases, TDFs are listed 45 years into the future.

While the majority of TDFs are actively-managed and often more expensive, some fund companies have recently started to offer passive TDFs. In these cases, the TDF portfolio is comprised of lower-cost index funds, which can boost net returns to investors.

Shortcomings of TDFs

Yet while the built-in diversification argument is a powerful reason to attract investors, it does not trump the fact that almost all target-date funds are composed of funds offered by a single mutual fund company or investment manager. This is why TDFs are called “a fund of funds,” which means the underlying individual funds are packaged into the TDF format. Individually, many of these funds included in the TDF would not be able to attract significant investor interest, often due to mediocre return performances and higher costs.

But since they are automatically part of the TDF portfolio package, managers seek to overcome their individual performance deficiencies. Even so, any expert baker will attest, it is difficult to bake a superior cake using mediocre ingredients. The same is true for TDFs. However, their portfolio diversification and changing risk profile over time remains a major benefit.

Other deficiencies of TDFs include high expenses, poor individual components and untested glide paths, which refers to the management of asset class exposures—especially fixed income—over time.

Risk management was another significant problem often neglected by managers, according to Joe Nagengast of BrightScope. “The aggressive [TDF] managers justify their actions by claiming they address ‘longevity risk,’ but all they really do is add market risk to longevity risk. Participants (especially those hoping to retire in 2008 and 2009) were badly burned by this strategy. The managers decided to avoid the need for principle preservation at the target date in favor of a simplistic, long-term, risky portfolio strategy.”

Nagengast, an expert in analyzing TDFs, has compiled a series of indexes to measure associations, risk and performance, as well as company management, fees, strategy, risk and performance. A 2013 report from BrightScope found that fees declined in 2014. Average fees in the lowest cost share class for each target date series was .65%, a decline from .67% in 2013 and down almost 10% overall since 2011. This is good news for TDF shareholders.

Fee competition has also prompted a few other fund companies, such as TIAA-CREF and Fidelity, to launch TDF funds with average expense ratios of 19 basis points (one basis point is one-one hundredth of a percent). An earlier study noted that most fund companies are “sacrificing returns” by adhering to 100% active management. In response, Vanguard has introduced a series of 100% passive, low-cost TDF funds.

While there is good news on fees, there is room for improvement. Some TDFs charge an overlay fee on top of the average weighted expense ratios of the underlying funds in the TDF. This overlay fee is similar to a management fee, or “wrap fee,” to handle the individual fund allocations over time. According to Nagengast, charging for an overlay fee is never justified, because it constitutes a double fee on TDF investors. This fee is not needed since the TDF’s glide path should not change over time. As a result, investors should question why any high management fees are needed.

The analysis of TDFs also found other significant problems in the following areas:

  • Risk management. The study found that many TDF families “continue to pay too little attention to risk, [are] too aggressive, especially just prior to, and at, the target date.” This helps explain why TDF investors were “brutally punished” by investment losses since November 2007 by strategies that were too aggressive.
  • Not enough asset classes. TDFs should include more asset classes to improve diversification.
  • More passive management needed. The analysis found that the industry “continues sacrificing returns in their superstitious preference for active over passive management.” The investment losses due to pursuing active strategies are borne by investors.

Conclusion: TDFs Still Offer Great Benefits

While the shortcomings of TDFs have been noted, they still offer individual investors a great package of portfolio diversification, professional management over long time periods and risk management. Looking ahead a decade or two, these funds can provide the needed diversification to deliver returns in conjunction with a disciplined savings program. That combination should be effective in boosting financial security for future retirees.

If you’re interested in learning more, read Chuck Epstein’s article on the keys to retirement success.

Rate This Article
Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

Help Your Business Thrive

Get our newsletter

Thanks for signing up!

Check your inbox for a confirmation email.*

*Check your spam folder if you don’t see a confirmation email.

Related Articles

101 Best Business Blogs You Need to be Reading (and Taking Lessons From)

There are many business blogs on the Internet. Some of the most…

Read more

106 Business Tools for Freelancers, Consultants and Side Hustlers

For freelancers, productivity is an asset. The more efficient you are, the…

Read more

How to Create an Invoice Online

Invoices are one of the building blocks of any business. But despite…

Read more