Inside, your investments are rotated, rebalanced and ready to serve for life after work. Of course, there are certainly performance and expense drawbacks to these target-date funds or TDFs: For a passively managed fund that's rebalanced every five years, retail investors are still paying a high cost of 0.84% on average in fees, and most TDF holders incurred losses of 50% or more during the Great Recession.
Still, people do love easy. TDFs are convenient and are at least becoming cheaper.
BrightScope, an investment research company, recently considered 561 target-date funds currently offered in 401(k) plans from 40 asset managers. Fund fees are down nearly 10% since 2011, falling to a current average of 0.65%.
Brooks Herman, head of data and research at BrightScope, says expenses have declined primarily for two reasons: the rising popularity of index funds and because 401(k) plan sponsors and participants are demanding lower fees.
TDFs receive the widest distribution in the 401(k) space through asset managers like Vanguard and T. Rowe Price (TROW). These firms often handle the administrative duties of the retirement plan as record keepers, too. However, more employers are choosing to separate those duties.
"What we are seeing are plan sponsors -- the people in charge of the 401(k) plan --- are actually moving away from proprietary target-date funds," Herman said. Instead of going along with a fund offered by a record keeper like Fidelity, employers are opting to select investments from 'off platform' providers. "That's a trend that we've been seeing [for] a couple of years."
Most TDFs are comprised of mutual funds, although exchange-traded funds have grown in popularity in nearly every other investment arena. In fact, two of the largest ETF providers have closed or are closing their target-date funds: BlackRock (BLK) shuttered its iShares TDFs and Deutsche Bank (DB) is liquidating its target-date offerings at the end of the month.
"No one has quite figured out how to make ETFs work in target-date funds yet," Herman said. He thinks it may be largely a technological issue related to the fact that ETFs trade throughout the day rather than just once at the market's close, like mutual funds. "Most record keepers don't actually have the technology platforms in place to allow for ETFs," he said.
But for the most part, TDFs are accomplishing a significant goal for investors: encouraging them to buy and hold, rather than constantly tweak their holdings.
"People like to 'set it and forget it,'" he said. “You want to buy it once and come back in 30 years and see how it did. You don't want to worry about rebalancing every year."
These goal-based allocation funds can be targeted to a retirement date or through it. Aiming for a specific date assumes the investor may roll over his or her assets to an IRA, while "through" strategies allow for the 401(k) to remain in place as a potential income-generating investment in retirement.
Based on the assets held, through funds are "massively more popular," Herman said. But this is likely not the result of a strategic decision made by investors. The three biggest asset managers in this area, Fidelity, T. Rowe Price and Vanguard, offer only through funds.
Many employers sponsoring 401(k) plans are beginning to assign target-date funds as a default investment for participants who choose to not decide how to invest their retirement savings. That's a bad idea, according to James Watkins, III, CEO of InvestSense in the greater Atlanta area, an investment education and "forensic" wealth management firm.
"I think the public and the plan sponsors don't really understand the way that TDFs work," Watkins said. The retirement target-based allocation funds "expose investors to an unnecessary level of risk that they aren't even aware of," he added.
TDFs use a preset mix of stock and bond investments, typically beginning with a larger stake in equities, which generally moves more to bonds as an investor approaches retirement.
"The problem with that is it's rather inflexible," Watkins said. "And so, if we see a change in either the equity market or the bond market, the prudent thing to do is possibly tweak it a little -- to reduce the allocation to that sector which [the investor feels] may be a little bit riskier. TDFs can't do that."
Watkins admitted that TDFs could be an "excellent product" -- if portfolio managers were given the leeway to adjust allocations, even if only slightly, to reflect prevailing market conditions.
"TDFs are inherently bad," Watkins said. "It's that lack of flexibility that I have a problem with. The inability of the TDF to go in and make adjustments to reduce risk to the investors."
An increasing number of investment management firms have, however, recognized the demand for such investment flexibility. Last August, Fidelity implemented “active asset allocation” for its TDF offerings, allowing portfolio managers to make investment adjustments of 10% (more or less) to the core allocation. J.P. Morgan Chase (JPM), Charles Schwab (SCHW), T. Rowe Price and TIAA-CREF are among the firms that offer similar tactical TDFs.