The Hidden Dangers of Target-Date Funds

Some target-date funds invest in risky assets and charge high fees.

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Target-date retirement funds permit 401(k) investors to select one mutual fund geared to their projected date of retirement. For example, a plan participant who anticipates retiring in 2035 simply selects a target-date fund closest to that year in the fund name. The fund automatically adjusts the asset allocation between stocks, bonds, and cash equivalents, becoming more conservative over time. The appeal of these funds is the ease of selecting only one investment, leaving the work of rebalancing the portfolio up to the fund manager.

These funds have been a huge hit with employees. By some estimates investments in target-date retirement funds are approaching $400 billion, with projected sales of $2 trillion by 2020.

On balance, target-date funds are an excellent idea. While brokers and insurance companies tout the number of investment options they offer to participants, I have found few employees capable of assembling a globally diversified, risk-adjusted portfolio from an extensive list of stock and bond funds. The primary benefit of target-date funds is their focus on asset allocation, which many studies demonstrate explains about 90 percent of the variability of a fund’s returns over time. By selecting these funds, employees avoid the temptation of market timing, stock picking, and manager picking—all of which are of far less consequence.

The selection of target-date funds as a prudent option has been validated by the Department of Labor and the Pension Protection Act of 2006, which designated these funds as “qualified default investment options”. This means that employers that automatically enroll employees in 401(k) plans can now invest participants in target-date retirement funds without fear of liability.

Before you change your current 401(k) selection to a target-date fund, you should be aware that not all of these funds are created equal. Here are some factors to consider:

Target-date funds aren’t right for everyone. Target-date funds are probably a smart choice for most investors. Exceptions include those with inheritances or other special circumstances giving them a higher net worth than the average employee. These investors may require a different asset allocation than the one offered by the target-date fund nearest their projected retirement date.

Different target-date fund families use different asset allocations. There can be a significant difference in the amount of risk you are assuming between two target date funds managed by different fund families, even though both of them have the same date in their name. According to one report, in 2009 Alliance Bernstein and Charles Schwab had target-date funds using 2040 as the projected retirement date. The Alliance Bernstein fund allocated 93 percent to stocks and had a one year loss of 30 percent. The Schwab fund allocated only 67 percent to stocks. Its one year return was a loss of 20 percent. You need to be sure you are comfortable with the level of exposure to stocks in the target-date retirement fund you select.

The cost of target-date funds varies wildly. You can determine the cost of any mutual fund by looking at its expense ratio. According to a recent article in Forbes, one version of American Funds Target Date 2025 Fund had an expense ratio of 1.5 percent. Other versions of the same fund had expense ratios as low as 0.42 percent. The comparable Vanguard Target Retirement Fund (VTTVX) had an expense ratio of 0.18 percent, which Vanguard indicates is 64 percent lower than the average expense ratio of funds with similar holdings.

Here’s the bottom line: Target-date retirement funds can be an excellent choice, but only if the asset allocation is right for you and the fees charged by the fund are reasonable.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read, and The Smartest Portfolio You'll Ever Own. His new book, The Smartest Money Book You'll Ever Read, was published on December 27, 2011.

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