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Target Date Funds: Panacea or Hallucinogen

By: Robert Gordon

By: Robert J. Gordon, MBA, AIF®, CFP®

2008 should be a banner year for Target-Date Retirement funds. After a slow start in the early 90s, this category of funds has grown rapidly to almost $200 billion in assets under management. Target-Date Retirement funds are popping up in company retirement plans across the nation thanks to the Department of Labor’s approval of their use in qualified retirement plans as a Qualified Default Investment Alternative at the end of 2007. This means that retirement plans, such as 401(k)s, can automatically enroll new participants in one of these investment vehicles if the participant declines to choose an investment option. They have been widely touted as the ‘set it and forget it’ solution to retirement investing. Despite the rave reviews, these funds are poor substitutes for a customized and comprehensive investment plan. Let’s look at a few of the key concerns related to Target-Date funds in the retirement planning context.

What are they?

Target-Date mutual funds are designed to simplify long term investing by allowing investors to select an investment that matches the length of time remaining until a specific goal must be funded. In most cases, they are marketed for retirement planning. The asset mix offered is typically some combination of equities and fixed income securities with the allocation being equity-heavy in the early years and declining gradually up to the target date. These funds are typically fund-of-funds meaning that the Target-Date fund is composed of holdings in other mutual funds. As a matter of fact, many of those funds belong to the same fund family as the Target-Date fund though this is not a requirement. The gradual change in the asset allocation is determined using a protocol or systematically-determined path referred to as the ‘Glide Path.’ Glide Paths vary among the various mutual fund companies. The chart below illustrates the ‘Glide Path’ or gradual decline in the equity allocation for one of the largest providers of these types of funds:

Forty years from Retirement Ten years from retirement Two years from retirement 5 years into retirement
% in equities 87% 65% 49% 25%

Will their performance protect me from inflation?

Assuming you are saving enough, inflation is one of the biggest threats to your ability to maintain a comfortable standard of living in retirement. Consequently, your retirement savings plan must include exposure to the global equity markets. Equities are widely considered the best ‘insurance’ against the ravages of inflation. Remember the Glide Path we discussed earlier, if it is too conservative (i.e. too little exposure to equities relative to bonds/cash), investors may not achieve their goals. As shown in the table below, there is significant variety in the allocation to equities among the various providers of Target-Date funds.

Fund Name % Stocks % Bonds % Cash & Other
Fidelity Freedom 2035 79.9 11.5 8.6
Vanguard Target Retirement 2035 89.2 9.8 1
T. Rowe Price Retirement 2035 87.8 7.7 4.5

* This is not an endorsement, either explicitly or implicitly of the aforementioned funds.

As funds-of-funds, these investments are particularly troublesome in taxable accounts where opportunities for tax loss harvesting are lost because withdrawals are taken pro-rata. For example, a $1,000 withdrawal from a 60% equities and 40% fixed income portfolio would be drawn as follows: $600 from the equity portfolio and $400 from the fixed income portfolio without regard to the actual performance of a particular sub-fund.

Prudent tax loss harvesting has been shown to increase after-tax portfolio returns and reduce portfolio risk. Additionally, the lost opportunity to shift distributions from volatile assets to stable assets during market downturns threatens the return performance and retirement fund survival.

What about the other funds in my plan?

Target-Date funds are designed for use as the only investment selection in a retirement portfolio – a point that is often overlooked by plan participants who create their own portfolios. Those participants frequently end up with concentrated positions in specific asset classes due to the overlap between the outside funds and the sub-funds of their Target-Date fund holding. Consequently, these investors unknowingly bear a high level of uncompensated risk and, with that, a decreased probability of reaching their retirement savings goals. Further complicating the situation is the fact that fund companies are still adjusting asset allocations in Target-Date funds to adjust to changing mortality statistics, lifestyle objectives and risk tolerance.

At the end of the day…

These funds fall short in their attempt to replace a comprehensive and customized investment plan that matches cash needs to specific allocation decisions and actions. Their pleasant convenience masks the unavoidable complexity of life and threatens the average worker’s ability to achieve a comfortable retirement.