The funds were created in 1994 to help investors simplify their decision-making in how to allocate and diversify their assets, especially as they get closer to retirement age. An investor who plans to retire in 2030 would have a lower percentage of risky assets such as stocks and more conservative ones such as bonds compared to someone retiring much later in 2055.
Target date funds are often viewed as a panacea by investors, said Robert Johnson, CEO of The American College of Financial Services in Bryn Mawr, Pa. The underlying premise is sound since the asset allocation of stocks and bonds is adjusted gradually as the investor nears retirement, saving the consumer the headache of choosing which mutual funds will generate the best return.
“While choosing a fund based on the date of expected retirement seems like a very logical thing to do, target date funds allocate assets based on what the fund managers believe is the best asset mix for the average individual planning to retire at a specific time,” he said. “Retirement income planning is a very complex process and can not be reduced to simply choosing a retirement date and a fund based upon that date.”
Investors are paying the price for the freedom of not rebalancing their portfolio. Retail investors have poured over $650 billion in target date funds. Yet for a passively managed fund, they are paying a high cost with average fees of 0.84%, said Janet Yang, a strategist, and Laura Lutton, director of manager research for equity strategies, in a Morningstar report. The average investor in open-end mutual funds paid 0.71% in expenses in 2013, according to Russel Kinnel, director of manager research for Morningstar.
Three-fourths of the assets of these funds are managed by Vanguard, T. Rowe Price and Fidelity, said Yang and Lutton. Part of the surge in the popularity of target date funds can be attributed to 401(k) plan sponsors who believe they are a viable option.
While the performance of these funds is rated by Morningstar, the company bases a large percentage of its rating on investment performance, said Ronald Surz, president of PPCA, a registered investment advisor in San Clemente, Calif. and a portfolio manager on Covestor, the online investing marketplace.
The funds which hold a large percentage of U.S. equities received the higher marks, because “U.S. stocks and real estate have skyrocketed in the past five years, leaving other asset classes in the dust,” Surz said. “Winning the performance horse race over this time period is more of a warning than it is a triumph. U.S. equities are risky and someday U.S. equity markets will correct.”
A large majority of target date funds are passively managed, meaning there is not a portfolio manager researching and choosing the stocks and bonds which are bought and sold for the fund. Many target date funds are only "rebalanced" every five years, which is when the shift toward more bonds and less stocks occurs.
“In what other industry would it be acceptable to get paid for doing work every five years?” said Mike Kane, CEO of Hedgeable, a New York-based robo advisor focusing on the downside protection in a bear market. “To put it bluntly, target date funds are the biggest marketing scam in the history of the investing industry. We can react to changing market conditions daily.”
Performance of Target Date Funds
During the financial crisis, holders of target date funds did not fare well. Most of them incurred losses of 50% or more, because they had a high concentration of equities, Kane said. While these funds are marketed as managing risk for the account holders, that strategy has proven to be a fallacy.
The longer-dated target date funds or those with retirement of 20 or more years in the future lost an average of 39% in 2008 and even the most near-dated "conservative" funds lost an astonishing 22%, Kane said.
The returns on these funds are the biggest drawback and outweigh the benefits of reducing risk, said Edison Byzyka, vice president of investments for Hefty Wealth Partners in Auburn, Ind. Investors can find better returns by simply investing in domestic and international equity indices in mutual funds or ETFs when they are younger and then “shift to a proper target date fund when faced with less than ten years to retirement,” he said.
“At the end of the day, performance is a crucial factor to a successful retirement and will likely influence your ability to sustain your lifestyle once retired,” Byzyka said.
Future of Target Date Funds
The popularity of these funds has been predicted to increase as more retirement money is poured into them. Assets in target date funds are estimated to grow to $3.4 trillion by 2020, according to Casey, Quirk, and Associates.
While these funds are designed so that the allocation will grow more conservative over time, managing your portfolio passively by holding onto the same assets means investors are more likely to experience greater risk and volatility, Kane said. Even if investors miss out on the “upside” or when returns are high, they have also eliminated the “downside” or risking large losses, which has a greater effect on long-term portfolio growth.
“Since markets don’t go up every year, investors don't realize the devastating effect losses can have on a portfolio because the hole is sometimes impossible to dig out from,” he said. “The market and our economy is resilient and will most likely go up over time, but the goal of investing is not to get back to even, it is to grow your money.”
If there is another market setback , there could be losses of $1.5 trillion or more for employees, Kane said. Investors may not comprehend the huge losses which can occur in these funds.
“American families deserve better,” he said. “Have we not learned the lessons of the financial crisis yet? Investors close to retirement are given assurances that their allocation will be safer and more ‘conservative. But what happens in a bond market collapse?.”
One-Size-Fits-All Method Fails
Investors are drawn to target date funds, because they are viewed as a cure-all for their entire retirement portfolio. Many investors do not want to read and research through all the options, so they choose a fund that has the year they wish to retire in, said Bijan Golkar, CEO of FPC Investment Advisory in Petaluma, Calif.
These funds have become even more popular in 401(k) plans, but the largest disadvantage is that “they try to be a one-size fits all solution to investors and can have very high internal expenses,” he said.
While reducing your risk as you get older appears to be a sound strategy, this overlooks people whose retirement accounts are woefully smaller because they started saving later.
“A person that is behind in their savings might need to have a much more aggressive allocation to try and catch up” Golkar said.
--Written by Ellen Chang for MainStreet