Understanding the Limits of Target-Date Investments
The popularity of target date funds, also known as life cycle funds, is on the rise, according to a new study from the Employee Benefit Research Institute (EBRI). According to the new data, 37% of 401(k) participants who are offered target date funds as an investment option elect to allocate some of their assets to the funds. In addition to traditional target date mutual funds, investors now have the option of new target date ETFs. While these target date funds provide a quick and easy solution for some investors looking to track the historical returns of the market, the simplicity of the target date fund model can also prove detrimental. As investors grapple with recent losses in their 401(k) portfolios and consider target date funds as a potential piece of their future investment strategies, it will become even more important for individuals to differentiate between the different available funds and understand positive and negative aspects of target date investments.
EBRI’s latest study shows that target date investments have become popular among a younger, less wealthy, investment profile. According to the study, 44% of 401(k) participants younger than 30 had a portion of their assets in a target date fund, opposed to only 27% of investors 60 and older. New target date investors are also generally younger and have relatively lower incomes. On average, the study found that target date investors are approximately 2.5 years younger than their non-target date investing peers and make about $11,000 less in salary. These younger target date investors have, on average, $25,000 less in their retirement accounts and have generally smaller plans.
In 2006, target date funds were approved as a type of “default fund” for 401(k) investment plans. This status allows target date funds to be used as an allocation method when a participant does not select a particular fund strategy on his or her own. Now, with an estimated $2.4 trillion lost from retirement accounts this past year, lawmakers and regulators have set their sights on target date fund advisers. Target date fund assets totaled $152.8 billion in 2008, compared with $177.7 billion in 2007. According to Morningstar, the Target 2010 fund from DWS Investments was the best-performing fund for the one-year period ending March 26, losing a mere 6.22%. In comparison, the Oppenheimer Transition 2010 fund lost more than 40% in the same period.
When investing in a typical target date fund or ETF, individuals pick the fund that correlates with their estimated retirement date. Over time, the fund rebalances and adjusts to mimic the changing risk tolerance that a typical investor might have—more aggressive earlier in life and more conservative near the retirement date. The typical target date mutual fund has recently faced some competition from the target date ETF spectrum. These ETFs, like the target date funds recently offered by iShares, now promise different sub-strategies for more aggressive or passive investors. Target date ETFs, while adding transparency and lower fees, further remove the participant from human intervention. When investing in these ETFs, investors should formulate an idea of what kinds of asset allocation, indexes and funds match their risk tolerance.
While target date funds are growing in popularity, some investment advisers are questioning their appropriateness as an investment strategy. Russell McAlmond, president and chief investment officer of Evergreen Capital Management Inc., recently noted, “Common sense will tell you just picking a year to retire should not be the basis for constructing an investment portfolio.” Advisers like McAlmond argue that the one-size-fits-all investment strategy does not easily match everyone’s needs. “The most important information you need to know about a plan participant is their risk tolerance, not which year they plan to retire.” McAlmond added, “As a financial adviser and 401(k) plan consultant, it is my ethical and legal obligation to know a client’s risk tolerance before ever recommending an investment.”
Risk tolerance is arguably the most important factor when developing a personal investment strategy—a factor that target date funds ignore. For both target date mutual funds and ETFs, investors simply provide the time frame in which they want to retire and enter into a prepackaged risk strategy for the long haul. As investors grow older, the funds are generally rebalanced to include a greater percentage of bonds and a lower percentage of equities—mitigating risk as investors draw closer to retirement. This strategy does not always work, however, and the recent market history demonstrates how the good intentions of target date funds can back investors into a corner. Consider a target date fund that exposed investors to the equity downturn of 2008 but is now rebalancing the portfolio toward safer investment strategies. In this case, investors would be exposed to the equity downturn without hope of an equity upswing. A regular evaluation of risk tolerance and market conditions could help investors to better time their investments and respond to changing life needs.
While the “set it and forget it” strategy of target date funds may not be appropriate for every investor, many of the new available strategies could help young investors alleviate the stress of rebalancing their retirement accounts in a difficult economy. Investors should remember that no single strategy is a cure-all for the time and energy necessary to formulate an individualized and complete portfolio. Target date fund investors should monitor their holdings, and track the performance of the funds relative to broader market benchmarks. When the rebalance arrives, the results are telling, and investors should keep a close eye on whether the objectives of the fund match those of their investment philosophy.
