Five Reasons I Hate Target Date Funds

Updated

I kind of hate target date funds.

They're supposed to make investing for retirement simple for people who don't want to choose among the options in their 401(k) plans. And, yes, picking a single fund that is (supposedly) optimized to your retirement date is easy. Sadly, it's too easy -- and people who want things easy will likely miss the many pitfalls of these funds.

Think this isn't your problem? You may unwittingly be invested in a target date fund. Many employers have been automatically enrolling workers in their 401(k) plans and putting them in a target fund, as the result of a 2006 federal law.

That's the main reason they're growing so fast. Target date funds hold $400 billion in assets now, and will grow to $2 trillion within a decade, according to a newly released report from Brightscope, a company that ranks 401(k) plans, and Target Date Analytics, which tracks target date funds.

That's a tsunami of money: To put it in perspective, it took the entire mutual fund industry 52 years to grow to $2 trillion in assets.

Before I explain why these funds are troubling, here's a look at how they work: Let's use "Edward" as our fictional worker. He is 36 and wants to retire at 65, in 2040, so he chooses a target fund labeled "2040." Let's call it the "Superstar 2040 Fund."

The Superstar 2040 manager invests Edward's money in a mix of stock and bond funds, reducing the exposure to stocks (and risk) as Edward nears retirement. (The shifting of that mix is known as a "glide path.") All Edward has to do is keep contributing to his 401(k) and let the manager take care of the rest.

Think twice, Edward! Here's why:

1. Some Funds Take Too Much Risk Too Late in the Game.

Imagine you were planning to retire in 2010, and had invested in a target date fund. On average, target date funds set to mature that year declined 37% between the market peak in October 2007 and March 2009, according to Morningstar. Ouch.

Why? Too much exposure to stocks. You would think that after a meltdown like that, fund managers would cut back on holding equities so close to maturity. Not so: The percentage of stocks that target date funds hold at their target date rose to an average of 43% in 2010 from 40% in 2007, according to the Brightscope report.

"Many fund companies failed to learn from the 2008 debacle, which failure will surely hurt participants again," the report concludes.

2. Risks Aren't Clearly Disclosed.

Why would target date funds expose older investors to that kind of risk? There's a debate over whether a target date fund should hit its most conservative allocation -- known as the "landing date" -- the year an investor retires, or provide for the rest of his life.

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One camp -- known as "to" funds -- thinks a target date fund should hit the target date and landing date the same year. Thus, our friend Edward retires in 2040 at age 65, just as the Superstar 2040 Fund cuts the percentage of stock it owns to its lowest level. About 40% of funds followed this philosophy in 2010, Brightscope found.

The other 60%, known as "through" funds, think they should provide for Edward for the rest of his life. Since people run the risk of outliving their money, this camp continues to take some risk after the target date so his money has a chance to grow. Thus the Superstar 2040 Fund wouldn't minimize Edward's exposure to stocks until 2050 or later, when he's 75 or older.

In short, it's critical to understand if you have a "to" or "through" fund to gauge your risk, especially if you had planned to take your money out in a lump sum on the target date. However, it's tough to figure out a fund's philosophy by looking at the fund documents. Even the gurus at the Morningstar, which ranks mutual funds, have complained that the data is hard to find.

3. Fund Managers Have Conflicts of Interest, and Mediocre Regulatory Safeguards.

So why would target funds hold so much money in stocks as workers approach their retirement date, when they'll need the money? Answer: More profit for the companies that manage the target date fund. Investors have to pay more for actively-managed stock funds than bond funds (or index funds, which simply mimic the major indexes such as the S&P 500). That gives the managers an incentive to stuff the target date fund with the more profitable (and riskier) funds.

Unfortunately, target date funds are subject to regulation under a 1940 law, the Investment Company Act, that doesn't have to teeth to stop a fund manager from putting his interests above yours. I'd rather see target funds governed by the stricter fiduciary standard, because its transaction and conflict rules are better at protecting investors.

This is a no-brainer: Shouldn't one of the fastest-growing investments for people who aren't paying attention to their retirement money be subject to the highest levels of accountability?

4. Target Date Funds Cost Too Much.

As noted above, target date funds cost too much. On the bright side, Vanguard recently launched target funds with very low operating costs. They have an expense ratio (or operating cost) of 0.18% as a percentage of the fund's net assets. Fidelity and TIAA-CREF followed suit with target funds that costs 0.19%. That compares to an average of 0.75% across all target date funds, Brightscope found.

What does this mean for Edward? Let's say he joined his company at age 35 and contributes $10,000 a year to a target date fund in his 401(k) for the next 30 years. The money grows at an average of 7% annually. When Edward taps the money at age 65, he'll have about $977,000 in the lower-cost target fund –$99,000 more than he would have the higher-cost one.

I'm sure we can all think of something more fun to do with nearly a hundred grand than forking it over to a fund manager. Vanguard has proven that target funds can be managed cheaply with solid performance. (It ranked fifth out of 34 companies in the Brightscope report.) So why can't competitors follow suit?

5. The Largest Players Crowd Out Better-Performing Competitors.

Finally, there's the stranglehold that the big, full-service 401(k) managers have on the target date market. This can prevent investors from getting access to the best-performing funds. For example, if Vanguard manages your 401(k) plan, you're likely to be offered a Vanguard target date fund as an option.

Vanguard likely won't offer access to American Century LIVESTRONG, which Brightscope ranked No. 1 -- four spots above Vanguard. In short, it's so profitable for the largest firms to keep a lock on the target date fund market they aren't going to make an effort to welcome other fund families in the door. In the retail world, that wouldn't fly: Imagine Walmart only offering Walmart brand toilet paper.

Vanguard's response: "For our full-service program... Vanguard offers a flexible investment program that includes both Vanguard and non-Vanguard investment products. Investment committees [at the companies selecting Vanguard] aligned with our perspectives on the importance of low cost, diversification, and the advantages of indexing in retirement portfolios typically consider Vanguard's index and target-date or balanced fund offerings best-in-class. We would look for such plans to offer Vanguard proprietary funds in those categories and as the default option for the plan."

What To Do

My advice? Don't play the set-it-and-forget-it game. Spend an hour a week at a website such as 401khelpcenter.com and learn how retirement investing works. Alternately, spend a few hundred dollars to visit with a fee-only financial planner who charges by the hour. Ask him or her to review the funds in your 401(k) to see if you would do much better by investing in the plan's other options.

But if this step (or its cost) makes you procrastinate, go ahead and invest in the target date fund. Just be sure to pop the ticker of your fund into the "quote" search box at Morningstar.com and look at the ranking and analysts comments to ensure you're not investing in a total clunker.

Then visit that planner when your investment hits $10,000 -- and you have enough skin in the game to care about your money.

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