The Unknown Dangers of Target Date Funds
Kevin Michels, CFP®, EA
Anybody that has participated in a 401(k) plan or has done some investing of their own has undoubtedly come across the new phenomenon we call Target Date Funds.
In fact, calling it “new” may be a misnomer since Target Date Funds have been around for over 20 years now. However, with the increasing popularity of companies offering a 401(k) plan, Target Date Funds have exploded as a simple, automated way to allow 401(k) participants to invest their contributions.
The idea behind Target Date Funds is to group together investors based on years until retirement and then manage the fund in a way that suits the generally accepted risk tolerance of those investors.
For example, if you plan on retiring in or around the year 2050, you could invest in a 2050 Target Date Fund. Generally, someone who has 30 plus years until retirement can invest aggressively with the idea that they have time to recover from major losses. Early on in the life of a Target Date Fund the asset allocation will most likely be aggressive around 90% stocks and 10% bonds. As time goes on the asset allocation will be re-balanced each year to become more conservative. By 2030 the fund could have an allocation of around 85% stocks and 15% bonds. By 2040, you’d most likely see an allocation of 65% stocks and 35% bonds. This process continues on until 2050 when, depending on the specific fund, the fund locks at a conservative asset allocation.
In my opinion, the idea behind Target Date Funds is genius. Most participants of 401(k) plans have either no idea how to invest their money, or just enough knowledge to be dangerous. In most cases, offering Target Date Funds allows investors to automate their investing in a manner that is suitable for their risk tolerance.
However, the important point to make is, not all Target Date Funds are created equal. Just because your 401(k) plan offers a line-up of Target Date Funds, does not mean you should invest in one blindly.
Just like all mutual funds, there are certain characteristics you need to look for in a Target Date Fund before you invest your money.
Understand how the “glide path” will work for your Target Date Fund
The “glide path” refers to the sliding asset allocation of Target Date Funds. As the years go on, the asset allocation of the fund becomes more conservative. However, the actual asset allocation varies from company-to-company. This has created a lot of confusion in the Target Date Fund arena and left a lot of people with their pants down in 2008 when they thought their asset allocation was more conservative than it really was. If you take the top 8 major players in the Target Date Fund industry and analyze the asset allocation on their 2015 funds you will see a large contrast on what is considered “conservative”.
2050 Target Date Funds
T. Rowe Price
Not to say that one fund company’s depiction of “conservative” is more correct than another, this just goes to show that a one-size-fits-all approach doesn’t always work.
The issue arises when a soon-to-be-retiree thinks their “conservative” asset allocation will protect them for a 2008 incident. For example, workers who were planning on retiring around 2010 may have been invested Fidelity Freedom 2010 fund. Those that didn’t have a good understanding of the real asset allocation of the fund were taken by surprised, hurt and angry when 25% of their retirement savings were wiped out in less than a year.
Once again, this isn’t to say that Fidelity is doing something wrong; their Target Date Funds are just catered towards those who have a higher risk tolerance.
In comparison, investors in the Wells Fargo Dow Jones 2010 Target Date Fund “only” lost 11%.
The point is, don’t blindly invest in a Target Date Fund without understanding and being comfortable with how the glide path will work for that specific fund.
Understand how Target Date Funds are built
In most cases a Target Date Fund is technically a “fund-of-funds.” In other words, when you invest in a Target Date Fund, you are investing in a fund comprised of 5 to 30 other funds.
If you invest in a Fidelity Freedom fund, your investments are actually split up between 27 different Fidelity Funds.
If you invest in a Vanguard Target Retirement fund, your investments are actually divvied up between 5 Vanguard Funds.
The point is, stick with those fund families that have a good reputation, solid track performance, and those that charge reasonable fees, because in the end you’ll actually be investing in a handful of the same company’s funds.
Understand the expense ratio of the Target Date Funds and other funds offered in your 401(k)
Simply put, fees eat away at returns. Over the long run, I truly believe the majority of index funds (funds that are passively managed and charge lower fees) will outperform actively managed funds (funds that are actively managed and charge higher fees). Similar to the differences in asset allocation between Target Date Funds, the expense ratios associated with each fund greatly differ as well. Most of this is due to the passive/active management approach each fund takes.
2050 Target Date Funds
T. Rowe Price
If the Target Date Fund option available to you through your 401(k) plan charges a high fee compared to the other fund options available to you, consider building a diversified portfolio using your other fund options.
Although Target Date Funds provide a valuable solution to the majority of 401(k) participants there is still danger in blindly investing in any one random Target Date Fund. Do your research.