Investing for Retirement: Target Date Funds Can Be Dangerous

Apr 13, 2015

Are your 401(k) dollars going into target date funds?  If so, take a closer look!  Obvious assumptions about these funds prove to be false.  Broad ranges exist regarding investment returns, underlying fees, and the appropriate allocation between stocks and bonds.  

Most 401(k) plans offer target date funds for participants.  These funds are touted as a one-stop shop for investors.  “Pick the target date fund that coincides with your planned retirement date, plow your contributions into that fund, and get on with your life.”  However, not all target date funds are created equally.  Investors should do their homework before jumping in.

Popular Destination

According to research from Morningstar, Inc., money in target date funds surpassed $700 billion at the end of 2014.  Target date funds are designed to offer instant diversification to investors.  Each target date mutual fund generally invests in a variety of other mutual funds representing different sectors of the market and different asset classes.  

The target date funds are also designed to adjust over time.  For example, an investor looking to retire in 35 years could buy a 2050 target fund.  As the investor ages and approaches retirement, the fund will automatically become more conservative, gradually shifting out of stocks and into more stable investments.  The set-it-and-forget-it nature of these funds has led to their widespread use and appeal.  But if we peek under the hood, things get a little more confusing.

Variation in Allocation

401(k) participants may see target date funds as the easy selection and make the assumption that any funds focused on the same retirement year have similar allocations between stocks, bonds, and other investment classes.  Unfortunately, this is not the case.  And as experienced investors know, the more assets dedicated to the stock market, the greater the risk of losing money in the short-term, but the greater the potential for growth in the long-term.

To make our point, we looked at the current allocation of 26 different target retirement 2020 funds (i.e. funds for people looking to retire in five years).  We found big discrepancies.  The percent that each of the 26 funds allocated to stocks varied from 20% to 65%. Within that stock allocation, the international stock exposure ranged from 15% of the stock portfolio to 48%.  Within the international allocation, the amount dedicated to emerging markets ran from 0% to 16%. The percent in bonds was between 35% and 70%.  We found some funds invest only in stocks and bonds while others included additional asset classes.  

In short, just because two funds have “target retirement 2020” in their name does not mean their portfolios look anything like each other.

So what are the “right” amounts of stocks and bonds for a person retiring in 2020?  Well, that depends – it depends on each individual’s situation, including: expected expenses in retirement, risk tolerance, other investment assets, and retirement income sources.  In other words, a cookie-cutter approach will not address significant differences in people’s situations.

Two Levels of Expenses

Something else to keep an eye on is the cost of your target date fund. There are usually two levels of expenses.  First, investors usually pay a fee for the target fund itself.  In our previous look at target retirement 2020 funds, the expense ratios ranged from 0% to 1.05% per year.  
In addition, the underlying mutual funds held in the target retirement fund each charge their own fees. These fees can also vary widely and may result in total expenses for the target date fund in the range of 1.25% to 1.85%. Investors would be well-served to dig in and figure out what they are truly paying.

Inconsistent Returns

As you would expect with such variations in holdings and fees, performance has varied widely.  Going back to the target retirement 2020 funds, 3-year performance through March 31, 2015, ranged from 4.21% to 10.18%, while 5-year performance ranged from 5.48% to 9.33%.  Only eleven of the funds have been around long enough for a 10-year track record.  Those performance numbers range from 4.35% to 5.66%.  

Summary

Target date funds are a good way to get instant and evolving diversification across asset classes.  However, investors need to dig into the details to understand exactly what they are buying.  It requires a little more upfront time and effort, but that is surely better than finding out ten years down the road that your fund had a lot more (or a lot less) risk than you realized.

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Prior to implementing any investment strategy referenced in this article, either directly or indirectly, please discuss with your investment advisor to determine its applicability. Any corresponding discussion with a Bedel Financial Consulting, Inc. associate pertaining to this article does not serve as personalized investment advice and should not be considered as such.

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