Posted on 01 July 2009
By Mark Miller
Target date funds need to sharpen up their aim.
These funds, which offer a way to put your 401(k) investing on cruise control, are taking a lot of heat due to the large losses suffered by some close-to-retirement investors in the market crash. At a Washington hearing last month, regulators threatened to impose new regulations and controls on these fast-growing investment products.
Target funds are good at addressing a basic problem with 401(k) investing–namely, that many people just don’t want to, or can’t, manage their own portfolios. That fact is reflected in asset allocations that often are shockingly inappropriate for investors’ ages.
Nearly one in four investors approaching retirement age (56-65) had more than 90 percent of their account balances in equities at the end of 2007, and more than two in five had more than 70 percent in stocks, according to the Center for Retirement Research at Boston College. Those concentrations are far too high for older investors, who don’t have nearly as much time as younger investors to recoup their losses before the funds are needed.
With a target fund, you simply pick a fund targeted for the year you expect to retire; the fund manager adjusts the asset mix as the target year approaches, reducing the percentage of equities and increasing fixed-income investments to make the overall mix more conservative.
Assets in target date funds have been soaring over the last few years, a trend that stems from the passage of the Pension Protection Act of 2006 (PPA), which included a broad set of needed pension reforms. One of the most significant provisions addressed the issue of investor inertia by clearing the path for plan sponsors to offer automated investment options called target date, or lifecycle retirement funds.
In a broad sense, target date funds offer an opportunity for investors to improve their asset allocations. The Employee Benefits Research Institute compared the equity percentages held by all 401(k) participants at the end of 2007 to the theoretical mix those same investors would have had if they were invested 100 percent in target date funds, which automatically adjust portfolio holdings for age-appropriate balance. The finding: 40 percent of investors would have had at least a 20 percent decrease in their equity concentrations.
But here’s the rub: The PPA doesn’t set any definitions for appropriate equity exposure levels by age group, so fund managers have been free to manage the investment mix as they see fit. As a result, target date funds have come under fire since the crash because many of the funds tailored for investors near retirement age racked up significant losses. Morningstar Inc. reported that target funds with dates between 2000 and 2010 lost 22.5 percent in 2008, and funds with target dates between 2011 and 2015 lost 28 percent. But those are broad averages; some funds with dates as early as 2010 lost as much as 50 percent of their value in 2008.
Clearly, many older investors thought they were buying more protection from market risk than that when they bought target date funds. The problem centers on the so-called “glide path” to retirement–the approach taken by fund managers to reducing your exposure to equities or other risky investments as you get older. Approaches here vary, but most of the big mutual fund management companies argue that investors need to maintain a healthy amount of equity exposure to help insure against the risk that they’ll outlive their money.
T. Rowe Price, for example, has an asset allocation glide path that starts with 90 percent equity exposure for investors more than 25 years away from retirement; that drops to 55 percent at age 65, 35 percent at age 80 and 25 percent at age 95 and thereafter.
These glide paths are based on analysis of long-term market performance showing that equities outpace other investment options, but they seem too aggressive for people within 10 years of retirement age, considering the highly uncertain outlook for markets and the economy in the years ahead.
At a joint hearing held in June by the Department of Labor and the Securities and Exchange Commission, there was debate about how target-date funds disclose their asset allocations, and whether the term “target date” may be confusing to investors.
Regulation of asset mix is under discussion, but seems far less likely to occur. So if you do use a target date fund, be sure to understand its glide path, and decide if you’re comfortable with the equity exposure. If not, you can fashion a more conservative investment mix and make plans to insure for longevity risk via another route–for example, an income annuity or deferred longevity policy.