If you have an employer-provided 401(k) plan, odds are that you’ve put at least some of your retirement assets in a “target date” fund. And if you haven’t specified your own 401(k) investment choices, the decision to automatically put all your assets in a target date fund has been made for you. Yet investing in these “set it and forget it” funds is no guarantee that you will be financially able to retire in whatever year you’ve targeted – it’s certainly no more guaranteed than it might be with another package of investment options.
“You don’t want to ‘set and forget’ anything in this kind of environment,” says Leo Grohowski, chief investment officer of BNY Mellon Wealth Management. “Over time, they can make sense, but they can also be less appealing than a portfolio with an asset allocation that is actively managed.”
The idea behind target-date funds is pretty straightforward, and so is their structure. If you’re 40 year sold and figure that you’ll want to be prepared to retire in 20 to 25 years’ time, you pick a 2045 retirement date target fund. It’s an easy choice, offering you a blend of stocks and bonds that will shift over time, as you approach that date, to emphasize safety and income. Certainly, it saves the average investor the time required to wade through a lot of other mutual fund prospectuses, choosing which ones to include and which to discard and then monitoring them and making adjustments as time passes, market environments change and managers retire or move on.
No wonder that the Pension Protection Act of 2006 cleared the way for them to serve as default investment options for 401(k) plan participants who don’t make other decisions. A Vanguard report (PDF) released in June estimates that 55 percent of plan participants will have all their assets invested in a target-date fund (or some other kind of product whose asset allocation is determined by the provider) by 2017, and that a whopping 80 percent of new plan members will have opted for these products.
But in investing, no product is “one size fits most,” let alone “one size fits all.” That means that you’d better be very sure that the target-date fund that is available on your 401(k) platform is the right fit – and you may even want to ponder whether it might make more sense to assemble a portfolio of funds that can be managed dynamically, in response to rapidly changing economic conditions and market trends – even if that requires more work.
The risks of target-date funds are being demonstrated this year, as the bond-market selloff that has propelled the yield on the 10-year Treasury bond a full percentage point higher has eaten into returns of target-date funds and left those that are particularly bond-heavy with losses. That has resulted in an odd and downright quirky anomaly: While in most cases, investors flock to the kinds of funds that are doing well and pull assets out of the laggards, this year has seen assets continue to flow into target-date funds even as they have disappointed.
Does this really matter? After all, everyone (yours truly included) is prone to chastise investors for chasing positive performance and shunning laggards. Again and again, you’ll hear that trying to time the market is a recipe for disappointment and even disaster.
In many ways, target-date funds are the opposite extreme. Yes, they are better than not investing at all; than putting all your money in a company stock fund or in a money market fund. But simply because the date on the target-date fund more or less corresponds with your own retirement plans, you can’t assume it will make for a great no-brainer investment. “They aren’t what they’re cracked up to be, or what many investors will be needing (in their portfolios) as this 30-year bond market plays itself out,” notes Grohowski.
In particular, investors who are closer to their retirement date are most at risk, as the asset reallocation process – referred to as the “glide path” – places more emphasis on bonds than stocks as time goes by. Those are precisely the investors who are most at risk: They have the least time available to compensate for any losses, much less try to make up for the modest gains they had hoped to earn. “They can’t afford the loss to their capital,” says Grohowski.
At the very least, if you want to concentrate your investments in a target-date fund, you should be doing at least as much research into it as you would put into investigating your other options. What are its fees and what is its asset allocation – and how do those compare with its peers, even if those alternatives aren’t offered on your 401(k) platform? Are you aware that a target-date fund doesn’t provide a guaranteed retirement income? Nearly two-thirds of respondents to a survey done for the SEC weren’t, or weren’t sure.
The smart approach may be to consider the target-date fund as simply one part of a broader portfolio. Consider your own financial circumstances – your risk tolerance, the kind of investments that you hold outside your 401(k), the safety of your job and the number of years that might elapse before your retirement – before letting a Fidelity, a Vanguard, a T. Rowe Price or other investment manager take the burden of your asset allocation decisions away from you. After all, the anticipated date of your retirement isn’t the most significant thing about you or your investment needs. Sure, doing this work is a burden, but you’re the person that has to live with the decisions and their consequences. The fund manager at Fidelity will likely be okay either way.
Best of all, think critically about 401(k) plan options as a whole. “Many (defined contribution) plans are guilty of chasing the ‘hot dot’ – the mutual fund with the hot performance right now – in an effort to show plan participants that they can include attractive funds,” says Grohowski. Many 401(k) defined contribution plans have been slow to offer alternative total return products or funds that are more benchmark-agnostic, such as what are known as enhanced beta funds. (An example of the latter might be an S&P 500 fund in which the 500 stocks are weighted equally rather than by market capitalization, meaning that a big decline in the likes of Apple or Exxon Mobil would have a less dramatic impact on performance.) Moreover, too many plan sponsors are still slow to offer serious education to their plan members: doing so is complex and not cheap.
Target-date funds might be convenient, but that convenience could well come at a cost. When the market environment makes that price tag more visible, it reminds us all that there really isn’t a shortcut when it comes to making wise investment choices.