Do Your Homework Before Investing in Target-Date Funds

Humberto Cruz

The ongoing and sometimes contentious debate over whether target-date funds have "failed" is missing some important points.

Target-date funds, the leading "default" option in workplace 401(k) plans, are mutual funds designed for people retiring in or close to a particular year.

For example, a 2025 target-date fund is intended for those planning to retire in or about 2025.

Their attraction:

Rather than struggle to pick the right mix of funds and manage them on your own, you choose a single, broadly diversified fund. The target-date fund becomes more conservative as it approaches its "target" date, gradually shifting money from stocks into bonds and other fixed-income investments.

While this "one-stop shopping" and instant diversification are appealing, the timing for the widespread adoption of target-date funds dreadful.

These funds exploded in popularity in 2008, with assets briefly approaching $250 billion, after the U.S. Department of Labor blessed them as one of the "default investment alternatives" in 401(k) plans.

Under the Pension Protection Act of 2006, that designation meant employers could direct employee contributions into target-date funds if the employee did not specify a choice.

Long term, choosing diversified funds for our retirement savings makes sense.

But diversification was no shield in the brutal bear market last year. With both stocks and corporate bonds tumbling, even target-date funds designed for people retiring as early as 2010 lost nearly 23 percent of their value on average in 2008, pushing overall target-fund assets down to $164 billion at year-end.

In the wake of those losses, target-date funds have come under a barrage of criticism.

Lawmakers, regulators and consumer groups have thrown around a number of proposals, including standardizing the stock / bond mix of target-date funds, which varies widely among fund companies; capping how much they can put into stocks near their target date, and creating different versions, from conservative to aggressive, of same-year funds.

Much of this debate rests on the faulty assumption that target-date funds can be complete "solutions" for retirement planning and that legislation or regulation can "fix" them to deliver on that false hope.

My view:

Target-date funds, provided we understand them and match them to our needs, can be important building blocks in our retirement savings plan. But we may want or need other components, such as cash reserves for emergencies and accounts specifically designed to generate income streams, such as bond ladders or income annuities.

One proposal, in a white paper by Christine Marcks, president of Prudential Retirement, calls for adding minimum income payout guarantees to target-date funds, even if their account value goes down. I should note Prudential sells annuities and other products offering those guarantees for a fee.

We also should not brand target-date funds as "failures" based on one year's results.

The 2008 bear market, "while devastating, is a short-term snapshot within decades of retirement saving and withdrawals," said Jerome Clark, lead portfolio manager of the T. Rowe Price Retirement Funds, in the company's Spring newsletter. Clark said research by T. Rowe Price continues to support the firm's relatively heavy stock allocation (55 percent to stocks on the target retirement date, declining to 20 percent 30 years after retirement) so the portfolio can grow and provide income that keeps up with inflation throughout retirement.

Ultimately - a point made in an analysis in the American Association of Individual Investors Journal in June - target date funds from different companies vary in strategy, asset allocation, historical return, yield and expenses, and we need to do our homework before we invest.

 

Personal Finances - Do Your Homework Before Investing in Target-Date Funds

© TRIBUNE MEDIA SERVICES, INC.