Let's Talk Target Date Funds: Investing While Hiding the Risk

On this weeks MomsMakingaMillion radio broadcast, the topic of target date funds is front and center.

The hosts Gina Robison-Billups of MIBN.org and Kat Belucchi of PensionsInc. asked the following question: Almost every 401(k) now has these funds. Many are used as default investments for new employees. But you have a long-standing problems with them Paul. Care to our audience why?

I have been on the record, with some decidedly trash talk centered thoughts about target dated funds in the past. Why do I think these are quite possibly the worst investment idea ever?

Let me explain what these funds are suggesting they can do and why, under the guise of protecting your assets as you grow older, they might not do as promised.

Shooting for a Distant Promise
A target dated mutual fund picks a date in the future that coincides with the year you would like to retire. So far so good. We all want to retire and we all have some idea when that time will be. For most, it it the arbitrary time picked for you by Social Security. For others it might be the moment, at age 59 1/2 when you can first tap those tax-deferred 401(k)s and IRAs.

Suppose you are 40 years old, your target date might be somewhere around 2030 or 2040, depending on what you do and whether you think you can do it for that long. You direct your money to a fund in your 401(k) that offers this date. These are in almost every tax-deferred account due to the Pension Protection Act of 2006 (perhaps one of the worst named pieces of legislation ever).

The fund prospectus suggests (you do read the prospectus, don't you?) that the fund will gradually shift from stocks to bonds over the course of that time frame, growing less aggressive as your account grows. This seems to fall into lockstep with what you have always heard about asset allocation and diversification. And it will be done automatically. No hassle investing for those who feel as though the whole process is too difficult to understand.

But what you fail to realize is that this is uncharted territory that has never really been navigated. Balanced funds offer something of a similar type of investing but usually hold steady at a 60/40 split between stocks and mutual funds. These investments however offer an actively managed approach to the process, a continuing shift in how the fund is invested.

The Success is Hard to Determine
This has not been done with any success in the past and may prove more costly - and more risky - than some investors realize. Some of these newly created funds hold orphan funds that, although they have not closed completely, would have had the fund family not stepped in to save it. This is out-sized risk that other investors have left for good reasons.

Many of these fund managers are entering into fixed income investing world with the idea that this might provide less risk. They may be incorrect in this assumption as bonds may see more problems down the road with inflation and deficit spending by the government, here and abroad.

There is also the question of performance as judged by the benchmarks. Many compare how well they have done against the S&P 500. But the need for new benchmarks still won't mean that these funds will be comparable. Ron Surz, president of Target Date Analytics suggested "The current practices [meaning investment styles] are all over the map. You could have 2010 funds with 90% equity to 20% equity. Any investor looking at the whole landscape is going to be challenged to what they like and what they don’t." And what they understand and don't.

Provider Accountability and Investor Assumptions
In a paper published by Vanguard Group that explored this problem, they describe benchmarks as holding "the provider accountable for the appropriateness of the return assumptions used in constructing the funds." They also suggest that historic returns are a reasonable guide for future results. If that is the case, many of us are in for a disappointment.

Currently, these types of funds employ a glide-path style of investing. But a paper published by Wilshire Funds Management believes this method needs to be rethought. In fact, they believe that a fund - and this might sound even more confusing - need multiple glide-path plans in order to make the fund work. If that happens, the "one-stop shopping" approach that these funds were advertised as doing, no longer works.

So what is an investor to do? While the industry struggles with the idea - and the SEC questions their methods and exposure to stocks - it is best to stay with a broad range of indexed funds across several market sectors or use the actively managed funds that do the same thing. Stocks still rule for the vast majority of us in large part because we simply haven't been investing that long to get any real benefit.

If you have to use target date funds, pick a date that is ten or twenty years beyond when you want to retire so you can get more exposure to stocks longer.