About half of American workers who participate in 401(k) plans have at least some of their money in so-called target-date funds, which continually rebalance portfolio assets throughout one's working life to maintain an age-appropriate level of investment risk. The premise of targeted funds is that the closer to retirement we get, the less risk we want in our portfolios. Targeted funds put the investor on a "glide path" to retirement that involves gradually supplanting riskier, growth-oriented assets with supposedly safer, income-generating holdings, so that by the target date, you're holding some optimal level of risk.
But do investors in these funds really understand what they're getting? Target-date funds are under a bit of pressure these days from federal regulators proposing stronger disclosure rules regarding their investment strategies and marketing practices. However the rules end up, though, it's probably best for workers to be sure for themselves exactly what they're invested in.
[See Evaluating Your Target-Date Fund Options.]
Issues surrounding investors' understanding of the funds arose following the crash of 2008-09, when many short-dated funds (those geared toward investors nearing their retirement date) did about as badly as the overall market, confounding older investors who'd thought they were better protected. In 2010, the U.S. Department of Labor proposed rules that would require marketing materials to provide more-prominent disclosure about how target-date funds work. Among other things, the rules would require "tagline disclosure"--stating the target date adjacent to the first use of the fund's name. For example, The 2030 ACME 40/50/10 fund would denote a fund that aims to hold 40 percent in stocks, 50 percent in bonds and 10 percent in cash by the year 2030. Funds would also have to provide both narrative and graphical explanations of how the asset allocation will change over time.
As the proposal gestates, a survey of investors commissioned by the Securities and Exchange Commission has found substantial confusion about how the funds work. For example, fewer than a third of total respondents (about half of whom own target-date funds) understood, correctly, that the year in a fund's name refers to the point when the investor stops purchasing shares. Some 30 percent of target-fund owners (and 12 percent of non-owners) believed incorrectly that the target date is when the asset allocation is at its most conservative.
Also, while substantial majorities understood correctly that target-date funds hold a mix of stocks and bonds and that the mix changes over time, about a third believed incorrectly that they promise guaranteed income at retirement and that the mix stops changing at the target date. Not necessarily; it depends on the fund.
[See Why Target-Date Funds Make Sense for Younger Investors.]
The fund industry has mixed views about the proposed changes. The Investment Company Institute, the industry's business association, generally applauds them, though it says tagline disclosure puts too much emphasis on the end game and not enough on how you get there. "In order to avoid investor confusion and to help investors understand that there is more to a target date fund than its asset allocation at the target date, this information should be introduced in its full context, not initially in a tagline," the ICI wrote in comments on the Labor Department proposal.
Others doubt tighter rules will make much difference for most investors. "I don't really think disclosing the asset allocation at that date would really help them that much to figure out which target-date fund would be best to get them to retirement," says Robert Hiltonsmith, a policy analyst at the progressive think tank Demos and a longtime critic of the whole 401(k) system. Aside from the relatively high fees target-date fund charge, "there's only so much disclosure can do when you get at the fundamental issue of [investors] not being able to make the right decisions with whatever information is at their disposal."
Investors sophisticated enough to have specific allocation preferences can probably build their own portfolios with low-cost funds and ETFs, some argue. What's more, tagline disclosure says little about what happens between now and retirement, or what stocks an equity allocation actually contains.
Lots of investors in target-date funds don't choose them at all, but end up there thanks to federal regulations that allow plan sponsors to place employees in Qualified Default Investment Alternatives when workers fail to choose for themselves. Previously, such people ended up in bonds. Most people don't have the interest or know-how needed to manage their own investments over the long haul--that's why we have fund managers.
[See 401(k) Fee Disclosure: Some Thoughts.]
But investment professionals disagree about whether these funds have worked as advertised. Target-date funds are "a way for getting your employees stock-market returns," says Brooks Herman, head of research at data provider BrightScope. "That's bad when the stock market is down, for sure, but over the course of 30 or 40 years, the stock market should outperform bonds."
The ICI argued in its comments that target-date funds, which are by definition long-term strategies, should not be judged by a single year's bad performance. "In fact, many argue that [target-date funds] did exactly what they were designed to do during the market-wide downturn," said the ICI. That is, "they followed a consistent asset allocation strategy, thereby allowing their shareholders to benefit from the subsequent market recovery."
Others see them as little more than a marketing gimmick. "Every fund company that has created one of these has done so to attract dollars from people that [supposedly] don't have the skills to invest themselves," says investment adviser Leonard Raskin. "I think the fund-management industry is constantly looking for new ways to have investors give them their money, and new ways to package products for investors that say 'this is easy once you pick a date'."
There's no way to know how the markets or your funds will perform over the long haul, but there are a few key things investors can ascertain about how these funds work, and what they do and don't promise:
There are many glide paths. The marketing premise of these funds--that there's a discernible "best path" to retirement security and that some fund manager knows it--appears to conflict with the widely divergent glide paths that various funds offer, even for the same target year. Your fund's prospectus should show what allocation it's planning and how it changes over the years, as well as provide parameters explaining how much the manager might deviate from the glide path. BrightScope says most target-date funds remain too aggressive near and at target dates. "We say, hey, when you're a current fund you should have zero percent equity," says Herman.
To or through. One big difference among targeted approaches whether the fund manages "to" or "through" a target date. In other words, does the fund stop adjusting assets when the investor ceases contributions, or does it continue adjusting afterward? The answer can make a big difference in where your allocations end up, particularly in the period 10 years either side of retirement, writes Morningstar analyst Josh Charlson. "Clearly, 'through' glide paths carry higher equity risk, fitting the belief that the risk of retirees' outliving their nest eggs requires more stock investments, over longer periods, in order to raise the probability of those assets lasting through retirement."
Fees. Spurred by low-cost Vanguard funds, competition is lowering fees. BrightScope says there are now three registered target-date fund series with fees at or below 0.20 percent, and that the average expense ratio for all target-date funds has dropped to 0.72 percent from 0.80 percent five years ago. That compares with about 0.75 percent for the average open-ended mutual fund. BrightScope's Herman says current fees are still "much too high."
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