How to Think About Target-Date Funds on a Bumpy Glide Path

Changes may be coming to lifecycle funds.

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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."