T arget date funds are the hottest product in the US retirement space. Assets in these funds have grown rapidly over the past five years – from $70bn in 2006 to $330bn in early 2011.
Target date funds are offered in a series. Workers invest in the fund with the year that corresponds to their expected retirement date. When the workers are young, the fund is tilted toward stocks; as the workers age, the fund shifts more into bonds.
The popularity of target date funds has been closely linked to the rise of automatic enrolment for defined contribution (DC) plans, under which all employees become plan participants unless they opt out. In 2006, Congress specifically authorised this enrolment procedure because it sharply increased participation in DC plans, especially among low-income workers.
When participants are automatically enrolled, the default fund option is critical – it becomes the sole investment of the plan participant who takes no action. Plan sponsors often choose target date funds as the default, assigning workers to a particular year by assuming retirement at age 60. These funds have become the favourite default option because they purport to meet the needs of workers throughout their lifetime – growing assets by holding a more aggressive asset mix in the early years and becoming more conservative to preserve assets later on.
However, lifecycle funds are inferior to a balanced fund – which keeps 60 per cent of its assets in stocks and 40 per cent in bonds (rebalanced annually) – for three main reasons.
First, the net returns of a balanced fund are likely to be higher than those of a target date fund. Over long periods, the gross returns of balanced funds are expected to be roughly the same as those of target date funds. No one can predict exactly when – during the 30 to 40 years of a worker’s career – equities will outperform bonds.
Yet, balanced funds have a consistent expense advantage over their more complex target date cousins, which periodically must change their stock-bond mix. At Fidelity, for example, the total expenses of its balanced fund are only 0.62 per cent of assets annually, compared to 0.74 per cent for its 2020 Target Date Fund and 0.84 per cent for its 2050 Target Date Fund.
Second, that complexity has also generated investor confusion about the risks and rewards of target date funds. After the financial crisis in 2008 – when almost all target-date funds lost 20 per cent or more of their value in a single year – some target date investors could not understand how their funds had lost any money at all; they thought their nest eggs were guaranteed to hold their value in the decade before retirement.
Moreover, each fund family uses different baseline asset allocation for its target date funds. That can lead to a wide dispersion in returns – even among funds with the same target year. In 2008, for example, AllianceBernstein’s target date fund for 2010 was down 31.8 per cent, while Vanguard’s 2010 fund fell 20.4 per cent. The differences make it much more difficult for investors to analyse and compare target date funds.
By contrast, investors in a balanced fund know exactly what they’re getting – 60 per cent stocks and 40 per cent bonds. Consequently, they are less likely to be surprised by losses in a down market.
The third problem with target date funds is that they assume everyone born in the same year will have the same investment needs at age 60. This is not true. Some 60-year-olds will have significant capacity to take risk while others will not.
Workers should be strongly encouraged to reassess their personal situation at age 50 and adjust their asset mix accordingly. Participants who intend to work until age 70 may decide the balanced fund continues to be the right choice for them. On the other hand, participants without a significant investment cushion who want to retire at age 60 may switch to a more conservative fund primarily holding bonds.
In short, the target date fund is too mechanistic; it lulls plan participants into thinking that all their retirement needs are being satisfied by this one fund for all time. In fact, participants at age 60 have different needs and time horizons for investing. It is impossible to say that a fund with 20 per cent, 40 per cent or 60 per cent in bonds works for everyone.
Retirement investing needs to be as easy as possible for workers, but it cannot be entirely robotic. Automatic enrolment works well to get workers started on retirement investing.
However, as plan participants start approaching retirement, they should be prompted, and given financial advice, to adjust their asset allocation to best match their specific situation.