Target Date Funds – Really? As Simple as Picking a Date?   Part I

By Michael Wilson

Target Date Funds (TDF) or Life Cycle Funds jumped in popularity after the passage of the Pension Reform Act of 2006. The Act allowed automatic enrollment of employees into employer sponsored 401(k) plans and also allowed plan administrators to offer investment advice to participants. Target Date Funds instantly became the go-to option for plan administrators as they offered a simple solution for asset allocation.

Many firms recently changed participants 401 (k) allocations to a Target Date Fund based on the age of the employee. Employees are allowed to change their allocation to something different, but once again it then falls on the participant’s shoulders to research and determine if the Target Date Fund they are in matches their objectives and risk tolerance. These changes came to my attention after it happened to my dad’s 401 (k). He asked me to look at the TDF they selected to see if it made sense for him. What I found after looking into the TDFs is that there is a wide range of interpretation regarding the appropriate level of risk acceptable for a specific target retirement date. One fund family’s version may not be acceptable to every fund holder. It is difficult to find a one size fits all allocation based solely on the age of the participant as every person’s situation and retirement needs are different.

Target Date Funds usually have a date in the title, a fictitious example would be Acme Target 2025 Fund. The date in the fund title is supposed to represent the year in which the owner expects to retire, in this case the year 2025. The funds follow what is called a glide path to retirement, dialing down the risk of the portfolio as retirement approaches. The risk level is typically managed by adjusting the mix of stocks relative to bonds and cash, i.e. reducing the stock exposure and raising the bond holdings as time passes and retirement nears. The idea is that this will help keep investors from making big allocation errors leading to losing a lot of the account just prior to needing it at retirement and also from being too conservative early in their career and not having enough for retirement. Makes sense right?

However, after the market collapse of 2008, TDFs came under scrutiny because of the relatively poor performance of some funds with a 2010 target date. The more time until retirement, or longer out the date in the fund title, the more stock the fund holds, conversely, near term dated funds should be the most conservative as retirement looms. Morningstar noted that the equity exposure, usually the most volatile or risky asset in the fund, ranged from 26% to 67% of Target 2010 funds. Obviously this is a huge difference in risk or volatility potential for a fund that is supposedly designed for individuals retiring in the very near future.

Some of the difference can be explained by whether or not the fund considers itself as managing to the retirement date or through the retirement date. The through retirement date funds consider that the holder may live another 20+ years and they leave a little more equity exposure in the fund at retirement and continue to move toward bonds after the Target Date. Others stop changing the mix at the Target Date and are already at their most conservative setting. The problem is this philosophy isn’t readily discernible in the fund title or description, again leaving it up to the investor to figure out if the mix is appropriate.

In summary, although TDFs are designed to help novice investors set an allocation for their retirement nest egg the actual practice of them varies so much in allocation that investors still need to know what mix is appropriate for themselves and can’t just rely on the date in the title.

Look for next week’s post where I’ll discuss what questions to ask yourself when determining whether or not a TDF fund is right for you.