Many employees who are automatically enrolled in their workplace 401(k) plan will have their money invested in a target-date fund, the most popular default investment. Target-date funds allocate your retirement savings into a range of investments including equities, bonds, and cash and gradually shift the investment mix to become more conservative over time. However, a Government Accountability Office report released last week found that target-date funds are not the ideal investment vehicle for everyone. Here are some key ways to evaluate your target-date fund.
Ascertain how the fund changes over time. Some target-date funds shift your money from equities to fixed income investments faster than others. “While target-date funds are designed to decrease the risk of investment losses as a participant approaches the target date, some target-date funds designed for those expecting to retire in 2010 experienced major losses during the financial market downturn of 2008-2009, placing the retirement security of many participants in jeopardy,” writes Charles Jeszeck, director of education, workforce, and income security issues for the GAO. The GAO review of 8 target-date funds found that all the managers allocated at least 80 percent of assets to equities 40 years before retirement. But when the fund reached the target retirement date in the fund’s name, one fund still had 65 percent of the fund allocated to equities, while another had an equity allocation of just 33 percent.
Determine the most conservative point. Some target-date funds reach their most conservative asset allocation when they get to the year in the fund’s name. This investment strategy is meant to insulate plan participants from excessive losses near retirement. Other target-date funds continue to reduce the equity allocation ten or more years into retirement to help ensure that retirees do not deplete their savings too quickly in old age.
Consider the underlying investments. Target-date funds employ a wide variety of underlying investments. There may be different classes of equities, such as domestic and international. The fixed income component of the fund could contain investment-grade bonds, high-yield bonds, and Treasury Inflation-Protected Securities. Some of the target-date funds GAO evaluated also invested in alternative asset classes such as real estate investment trusts, other forms of real estate, or commodities.
Find out the management style. Most of the target-date funds GAO studied were composed of actively managed funds, with the belief that a fund manager will be able to beat general market indexes over time. GAO found only one fund primarily invested in passively managed funds. In some target-date funds, all of the underlying funds are limited to mutual funds operated by the firm offering the target-date fund, while other target-date funds may include mutual funds managed by the same and other firms.
Aim for low costs. Some target-date funds will charge you considerably more than others. The most expensive target-date fund in GAO’s analysis cost about nine times as much as the least expensive fund. Asset-weighted target-date fund expense ratios ranged from 0.19 percent to 1.71 percent. Target-date fund fees are generally based on the costs of the underlying mutual funds, GAO found. Some target-date funds also apply an overlay fee for the costs of establishing and managing the fund.
Don’t expect guaranteed returns. Just because a target-date fund performed well in the past does not guarantee that it will continue to perform well going forward. “Target-date funds with the same target retirement year performed quite differently in recent years,” according to the report. Between 2005 and 2009 annual returns for the largest 5-year-old funds ranged from 28 percent to -31 percent. Target-date funds offer no guarantee that you will have enough money to retire when you reach the date in the fund’s name.