4 Myths About Target-Date Funds

Research shows that popular retirement-plan holdings are widely misunderstood by investors.

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It turns out that target-date funds, which are designed to be a simple, hands-off solution for investors, are widely misunderstood. Investors often mistakenly think these mutual funds provide guaranteed returns that begin at age 65, researchers have found. Even after the funds' purpose and methods were explained in an online research project, participants continued to associate the funds with Social Security-like guarantees that carry little or no investment risk.

Target-date funds have become popular default investment choices inside employer retirement programs. They are designed to automatically shift their investment holdings out of stocks to bonds to meet the increasingly conservative goals of people as they age and move into retirement. Yet the funds carry substantial investment risks. Even funds designed for people retiring next year, for example, include large percentages of stocks. That's because they are designed to support retirement plans, or glide paths, that extend 20 or 30 years into the future.

The consumer-reality disconnect is important. When 2010 target date funds—designed for people turning 65 next year—lost 25 percent of their value in 2008, outraged investors triggered a wave of sharp criticism of 401(k) retirement plans in general. (These funds posted their sixth consecutive quarterly loss in the first quarter of this year.) Legislation has been introduced to change the way the plans operate and subject mutual funds to more regulation, particularly in broadening their reporting of the fees they charge.

[See Retirement Mutual Funds: An Endangered Species?]

Morningstar analyst Greg Carlson says most target-date funds are well designed to deliver on their objectives. He supported the funds before the market collapse and still does. But Carlson also notes that their best feature—automatic diversification that is supposed to protect investors against harmful losses—provided scant protection last year. "What we've seen is a bear market that had a very broad sell-off, not just in equities but across the board," with sizable losses on supposedly safe bond funds as well. "Diversification didn't help very much," he says, "and that's obviously the selling point of these funds."

The consumer research was commissioned by Envestnet, a Chicago-based firm that provides support services to financial advisers. Michael Henkel, managing director of retirement services, said the project launched after reaction to market losses revealed a "vast misperception" about the funds, "even among very educated individuals." Even Wikipedia had the wrong explanation of the funds, he recalls, prompting Envestnet staffers to change the entry. Henkel says he expected consumers might not understand the details of target-date funds but says even he was surprised by how poorly they answered the research questions.

Only 16 percent of the 250 adults interviewed had even heard of target-date funds. The research provided people with this composite description of target-date funds, pulled from the marketing materials of three unnamed fund companies:

For investors looking to simplify retirement investing, target-date funds offer a convenient one-step approach. Each fund is structured as a "fund of funds," investing in other mutual funds to offer a broadly diversified portfolio of stocks and bonds. Each fund provides an asset allocation strategy that the fund managers consider appropriate for investors at various stages of the retirement planning process—both before and after retirement.

Asset allocation is your mix of stock, bond, and cash investments. It has the biggest impact on how your portfolio will perform over the long run, so it's the most important investing decision you'll have to make. Target-date funds make your initial asset allocation decision simple. Each fund has an asset mix that's appropriate for someone planning to retire in the target year. Simply pick the fund with the date closest to your expected retirement and you get an allocation that's appropriate for the number of years you have left to save.

"What's more, a target-date fund helps you maintain a sensible allocation all the way through retirement. That's because as time goes on, it gradually invests more conservatively. For example, target-date fund '2045' starts out with a lot of stocks. As retirement approaches and then begins, the fund automatically shifts to more bonds. You never have to wonder when or how to adjust your asset allocation—your target-date fund does it automatically.

The research included four areas where people who were surveyed reached the wrong conclusions about target-date funds:

Guaranteed income. After reading the composite description, 61 percent of respondents still thought the funds provided some form of guarantee. Nearly 70 percent incorrectly thought the funds would deliver one or more of these promises:

"Funds at the time of retirement."
"Secure investment with minimal risk."
"It's like a guaranteed return on investment even when the market bottoms out."
"A comfortable retirement."

[See 3 Cautionary Tales of Target-Date Funds.]

All funds are alike. Nearly 85 percent of consumers said target-date funds of different companies would be similar if they carried the same target year. Actually, there may be substantial investment differences among fund families.

High potential returns are all that matter. Target-date funds with heavier equity weightings also projected higher potential returns. That's to be expected, but such portfolios also carry larger risks of losses. Still, consumers heavily preferred the more aggressive portfolios—even though it was such weighting that contributed to 2008 losses.

Little focus on savings rate. Consumers were asked the five most important things about their target-date fund decisions. The number one answer was picking the right retirement date year—something Henkel observes is just about automatic with all retirement-plan programs. The decision, he says, is tied most significantly to retirement outcomes—how much to save—came in last place among the five.