Money flowed into target-date funds at a record rate this year after the U.S. government approved them as the preferred retirement investment for workplace savings plans. But many of those new investors may be disappointed when they get fund statements showing meager returns in the midst of a big stock rally.
Designed as "set-it-and-forget-it" retirement solutions, target-date funds are tailored to a person's investment needs based on their retirement age rather than chasing maximum returns in all markets. Because the funds are invested heavily in bonds, they were damaged in May and June by the worst bond market sell-off in a decade. Quarterly fund statements for many workplace plan participants will show no gains.
Does that mean it was a mistake for the government to push the investment funds as if they were USDA-inspected pieces of beef? Not really, fund experts say. Just as too much red meat can be bad for your health, target-date funds might not be right for everyone in every situation, fund analysts say. The funds vary widely in fees, quality and performance, and they may be a bad idea for some investors. But the sound principle of diversified investing underlies all of the major funds.
In its recently released comprehensive review of target-date funds, Morningstar rated two of the three most widely held fund families – T. Rowe Price and Vanguard – as the best of the top fund families in performance and quality. It rated Fidelity, the largest, "neutral." The report, compiled by Morningstar's Ibbotson Associates research unit, says that on average, target-date funds on the whole lost 0.6 percent in the latest quarter. For the year ended in June, their average total return was 11.9 percent, still less than half the 23 percent gain for the Standard & Poor's 500 index.
"The important point here is that people are saving," says Jeremy Stempien, director of investments at Morningstar Investment Management. "The funds diversify across different assets. And that's good. That way, you don't get killed by any one of them."
That might not reduce the "sticker shock" in store for investors whose statements will show a loss for the latest quarter and year-to-date returns of between 2 percent and 6 percent while the S&P 500 has soared 18 percent. Those low returns reflect the funds' high exposure to bonds, which fell 2.3 percent from April through June, according to Barclay's Aggregate U.S. bond index. High-quality U.S. government bonds and Treasury Inflation-Protected Securities, which many funds contain, were hit even harder, with losses of 7 percent to 10 percent in May and June alone.
Regardless of the low returns, the ownership of target-date funds soared 27 percent this year to more than a half-trillion dollars, largely because the funds became the government-backed investment option for 401(k) plan sponsors. The means workplace plans can fulfill Department of Labor rules by offering them. Under those rules, employees who do not elect an investment will be auto-enrolled unless they opt out of contributing a portion of their paycheck to the retirement plan.
With their unique position as the default investment for American retirement saving plans, target-date funds get lots of scrutiny. During the 2008 crash, some were criticized for having too much money in risky equities, especially in funds geared for people in retirement or close to it. But in sticking to their long-term conservative practice of diversifying away from stocks, they added to risk this year.
"When an asset manager tries to knock it out of the park by getting the maximum return in stocks, they are taking on too much risk for this kind of fund," Stempien says. "But the pendulum may have shifted too much toward fixed income."
The fixed-income portion in these funds cut overall returns by as much as half this year. Some were hurt even more because they held significant amounts of two of the worst-performing bond asset classes this year: TIPS and emerging-market debt. Significant losses also came from exposure to falling commodities.