Target-Date Funds: Hidden Risks In ‘Simple’ Plans

Quoted on (11.18.09)
Target-Date Funds: Hidden Risks In ‘Simple’ Plans
By Sheryl Nance-Nash

It seems simple enough. You know what year you plan to retire, so you pick a mutual fund with that same date, set it and forget it.

No wonder target-date funds in 2008 had their highest year for net new cash flows — at an estimated $57 billion. This year, cash flows are on track to set another record, accumulating at an annualized rate of $60 billion over the first seven months of 2009. In total, more than $140 billion has entered target-date funds since the start of 2007, according to Morningstar (MORN).

“Target-date funds now occupy the extraordinary position as the default investment choice for America’s new retirement model,” says John Rekenthaler, vice president of research at Morningstar and co-author of the firm’s Target-Date Series Research Paper: 2009 Industry Survey.

That distinction is a good reason to give the funds, which typically have a mix of stocks, bonds, international stocks and bonds, and sometimes other assets like real estate and commodities, a second look. Investors should be aware that target-date funds don’t offer any guarantees — in fact, they don’t provide any better asset or income protection than a simple constant stock/bond mix, says Michael Edesess, author of The Big Investment Lie.

While Morningstar generally is supportive of target-date funds, Rekenthaler highlights some concerns.

Concern No 1.: Fees Can Get You in the Long-Term

Target-date funds have an average expense ratio of 0.69 percent, which is lower than the 0.82 percent, figure for so-called “allocation” funds, which also invest in a broad mix of stocks and bonds. However, there is a broad range, on the low end of 0.19 percent to 1.82 percent, more than nine times higher than the lowest fee and a full percentage higher than that typical of “allocation funds”.

“While the costs are not bad, the issue of expenses is particularly important with target-date funds because of their very long time horizon. The power of compounding greatly magnifies small differences over such a long period,” he adds.

Concern No. 2: Keeping it All In-House

The propensity of these funds toward investing in only their firm’s proprietary products is problematic for Rekenthaler, as well as others, such as Jim Scheinberg, managing partner of North Pier Fiduciary Management, “Most target-date funds invest in the asset management firm’s own offerings. Seldom, if ever, will one company have superior choices for each asset class,” says Scheinberg.

That “closed” system is not a best practice, says Rekenthaler. “I can see why it’s good for them to keep their business in-house, but it’s not necessarily best for investors,” he adds.

Concern No. 3: Managers With No Skin in the Game

Although target-date funds are marketed as being for everyone, that doesn’t seem to include the funds’ managers. “There is a lack of manager ownership. Most don’t have skin in the game,” says Rekenthaler, who takes issue with this because Morningstar research shows that there is a relationship between how much money a manager has in his or her fund and the fund’s performance. Funds where managers have significant investments themselves tend to have better performance. “You like to see a doctor taking his own medicine. How else can we be sure it’s good?” points out Rekenthaler.

Concern No. 4: False Assumptions of Safety

You can also make no assumptions. The “glide” path (change in asset allocation over time) varies among products with similar retirement dates.”Do not just rely on the ‘target date’ and substitute that for your own analysis,” warns Clint Edgington, co-founder of Beacon Hill Investment Advisory.

For example, not all 2020 retirement funds are built the same. There can be large differences in equity exposures, some that are vastly more aggressive than others as retirement approaches, points out Craig Israelsen, co-author of Your Nest Egg Game Plan. “The problem is that people may not realize how exposed they are,” adds Rekenthaler.

Concern No. 5: What’s in This Fund, Anyway?

The problem of of people not knowing their risk exposure derives directly from the lack of transparency. “They aren’t doing a good job of saying what’s in the funds. The details are hard to find, buried. That information should be right up front — how much is in stocks, bonds and cash, and how this relates to other funds in the category,” says Rekenthaler.

Concern No. 6: They’re Not Designed for the Retirement Years

Perhaps the most serious limitation, says Israelsen, is that target-date funds are designed for the accumulation period (the years prior to retirement), but most are marketed as being appropriate for the accumulation period and the distribution period during retirement. “In fact, a target date fund should hand off the baton to a portfolio that is specifically designed for the ‘distribution portfolio’ at the stated target date. Target date funds are a generic portfolio model that is okay for investors between the age of 20 and 60, but by age 60 life can be more complicated and more individualized. At that age, “There is no such thing as a perfect investment for everyone. People have unique needs,” says Harley Lance Kaplan, a certified financial planner with Cantella & Co.

For the most part, what ails target-date funds, says Rekenthaler can be cured with disclosure. He adds,”These funds are a useful and productive addition to the industry, but they must improve further, if they are to fully earn their position as being at the heart of America’s retirement future.”