10 Things You Need to Know About Target Date Funds
At $2 trillion and growing, Target Date Funds (TDFs) are the darlings of 401(k) plans. You may be among the millions who are invested in TDFs. If you are invested in a TDF, or thinking about investing, here are 10 important facts about Target Date Funds you need to know.
1. One size fits all
Target Date Funds are commingled vehicles offered as mutual funds and collective investment trusts. Each fund follows what is known as a “glide path” that adjusts risk through time, starting at high risk and becoming more conservative as the target date gets closer - for example, the year you retire. This path and the underlying investments are identical for all investors in the fund.
2. Might be too risky, or not risky enough
Most TDFs have similar risk exposures when the horizon is long at about 80% in equities (stocks). But risk at or near the target date ranges from 15% in equities to 70% depending on the investment philosophy of the fund manager. Some say risk, when investment horizons are decades in the future, is too high. Some say risk exposure near the target date can also be too high, but again that is the decision of the fund manager, who does not know you or your specific requirements.
One of the stated benefits of TDFs is diversification, but this is simply not true for most TDFs because they are concentrated in US stocks. If your TDF is 80% invested in stocks, 80% of your investments are impacted by the same economic events. That is not diversification, it is concentration.
4. Tax inefficient
Because they are designed to be owned in tax exempt accounts like 401(k)s and IRAs, TDFs are not tax efficient, and don’t claim to be tax efficient. This impacts investors who are investing in TDFs outside of tax-deferred vehicles.
5. Limited choices
There are about 40 TDF mutual fund families, but the choices are far fewer than 40. If you’re in a 401(k) plan, there is only one choice, selected by your employer. If you’re choosing your own TDF, you can break TDFs into just two groups – aggressive and safe. The risk tolerance of a high percentage of investors in the middle (moderate, balanced).
6. No guarantees
Many think that their investments in TDFs are guaranteed to not lose money. That’s simply not true. In fact TDFs lost more than 30% in 2008. A TDF is no different than any other mutual fund that is invested in the securities markets. The principal variable is the glide path. The funds are subject to loss when the markets decline in value.
TDFs are designed to be your entire portfolio. Adding other investments to a TDF, like stocks or bonds, defeats the design of the fund. That’s because other investments do not have glide paths and other investments may impact your risk exposure when you combine the two together.
8. The TDF market is an Oligopoly
Just 3 firms – Vanguard, Fidelity and T. Rowe Price – manage 65% of the TDF market. Oligopolies are not good for investors for a variety of reasons, like stifling innovation. Their dominance is based on trustees selecting brand names to run their TDF portfolios versus lesser known firms that may provide superior services. Trustees believe they will not be criticized (breach of fiduciary duty) if they select one of the Big 3.
9. Questionable objectives
TDFs are sold as replacing pay upon retirement and managing longevity risk. These are great objectives, but they are best achieved by saving enough versus betting the stock market will make up any differences that may exist. No investment plan will sufficiently compensate for inadequate savings. A better, more sensible, objective is to protect against loss of principal, although most TDFs do not provide this protection.
10. No brainers
TDFs are for people who don’t want to learn about finance, research investment alternatives, or make investment related decisions. They prefer a one decision “set-it-and-forget-it” approach. In doing do, they give up control of their financial futures.
There is an alternative for people who want to exercise more control over their investment strategies for assets outside 401k plans. Instead of investing in Target Date Funds, they can invest in Target Date Portfolios. Portfolios can be tailored to the requirements, circumstances, and goals of individual investors. Instead of being invested in mutual funds, that pool assets for investment, they can have their own individual portfolios, clearly a better way to go because all 50 year old investors are not the same.You will want to use a good financial planner and investment advisor if you decide to go this route.