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Target Date Funds: A Simple Premise, but Underlying Complexities

The allure of target date funds is simple: a single fund that provides a diversified portfolio and alters its allocation as shareholders approach the date when cash withdrawals will be taken. The promise of an “all-in-one solution” to investing for retirement is attracting both investors and employers. Yet, behind the simple appeal are complex strategies that offer more volatility and risk than these funds are perceived to have.

A target date fund is a mutual fund or an exchange-traded fund (ETF) designed so that its portfolio strategy evolves as a specified date nears. The date is listed in the fund’s name—for example, the Fidelity Freedom 2020 fund (FFFDX) is designed with a target date of 2020. An investor planning to retire in 2020, or within one or two years of that date, would consider investing in this fund.

As the target date moves closer, these funds change their composition to adjust for the level of risk the fund sponsor believes shareholders should be taking. The actual allocation and how often the allocation changes vary from fund to fund. Furthermore, at the target date, a fund can either adopt a final allocation or continue to evolve.

 Target date funds are funds of funds. Instead of holding individual securities, they hold shares in other funds from within the same family. Fidelity target date funds, for instance, invest in other Fidelity funds. This allows the target date fund manager to focus on making allocation decisions instead of also having to consider what securities should be held. The downside is that an investor has no control over the funds chosen and is locked into the target fund’s family.

Shareholder Confusion

Any discussion of target date funds needs to start by addressing their biggest problem: Many investors don’t understand them. The premise of a single fund that fulfills an investor’s needs is appealing, but the simplicity of the pitch veils the underlying complexity and volatility of these funds. In 2008, target date funds were criticized for incurring larger losses than investors perceived they would incur. Four years later, a study by ING found that a large number of investors still don’t understand the very basics of target date funds (Target Date Funds Misunderstood,” April 2012 AAII Journal.) According to the study, just 44% of investors surveyed knew that a target date fund’s allocation is designed to automatically change over time.

Part of the problem may be that many investors simply don’t read the funds’ prospectuses. This is unfortunate because these documents, provided by every fund family, explain how a fund is designed, its investment strategy and expenses, and other important information. Target date fund prospectuses also provide information about how the allocation is designed to change over time and what happens both at the target date and afterward.

Another problem is that allocation strategies themselves may be misunderstood. A goal of a long-term allocation strategy is to find an optimum mix of long-term return and risk. A proper allocation strategy does not avoid losses; it helps to reduce the amount of risk to a level that is appropriate for a given investment time horizon and wealth level. Since target date funds cannot be adjusted to account for the wide variances in wealth among their shareholders, these funds are managed solely on the basis of time horizon. An investor with a long time horizon can tolerate significant short-term volatility since he has several years to recoup any bear market losses. Conversely, an investor with a short time horizon does not have as much ability to recoup market losses. Thus, as a person nears retirement or becomes fully retired, his portfolio’s allocation should become more conservative.

Bear Market Volatility

Allocation strategies are intended to control risk, not eliminate it. During bear market cycles, target date funds will lose money. In 2008, the losses were greater than many investors had anticipated.

The table below shows performance and expense figures for the largest target-date funds, as well as similar Thrift Savings Plan and iShares funds. The bear market return column shows how each fund performed from November 1, 2007, through February 28, 2009. Using 2020 funds as an example, you can see how the T. Rowe Price Retirement 2020 fund (TRRBX) suffered the worst performance, losing 43.6% of its value. This was largely because TRRBX had the largest allocation to stocks of the funds shown. When the market rebounded, TRRBX led its peers with a bull market return (March 1, 2009, through March 31, 2012) of 87.6%. More stocks equal more volatility.

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Target date funds follow long-term allocations strategies; they are not designed to time the market. When prices for their largest asset class swing, so does the net asset value of the funds. Therefore, while target date funds will keep your portfolio allocation on track to achieve your long-term goals, they will experience volatility over shorter periods of time. Any investor planning to use target date funds must, therefore, approach them with the intent of holding such funds for the long term, rather than panicking and selling during bear markets.

All the funds have a mechanism for bringing their allocations back to the intended composition when market volatility causes one asset class to become too large or too small. The triggers for when this rebalancing occurs were not stated in the prospectuses reviewed for this article, however.

How Do You Choose?

There are two primary characteristics you want to consider when choosing among target date funds:

  • the amount of volatility you are comfortable withstanding leading up to and at your retirement date, and
  • the post-retirement allocation you think you will be comfortable with.

Your intended retirement date will influence the “year” of the target date funds you choose (e.g., 2015, 2020, 2025, etc.). If you plan to retire in 2020, the seemingly obvious choice would be to select a 2020 fund. However, if you do not expect to be reliant on your portfolio for retirement income—thanks to a pension or other sources of income—you could choose to go with a 2025 fund instead. A later-dated fund will give you a greater allocation to stocks at retirement and thereby more long-term growth. On the flipside, if you don’t think you will be able to withstand a bear market near your retirement date, you should consider a shorter-dated fund, such as a 2015 fund. Such a fund will have a smaller allocation to stocks on your retirement date, reducing downside risk and providing more portfolio income.

The trade-off for choosing a fund with a date that precedes or occurs after your retirement date is that you are either giving up potential portfolio growth or risking more market volatility. There are always trade-offs in investing, and while target date funds offer the allure of simplicity, they do not negate the tough decisions that an investor has to make.

Once the date for a fund is selected, the next step is to select an allocation glide path. As previously shown, each fund family has its own strategy for gliding to the final portfolio allocation. Vanguard evolves to the conservative allocation within seven years of retirement; T. Rowe Price takes 30 years. The Vanguard strategy will give you a more conservative, income-producing strategy sooner in retirement. The T. Rowe Price strategy will give your portfolio more opportunity to grow at a rate faster than inflation during your retirement years, but at the risk of increased volatility.

None of these funds moves out of stocks completely during retirement. Rather, it is the pace at which they reduce the exposure to equities in retirement that differs. It is up to each investor to determine his comfort level.

Performance and expenses do matter, but both are influenced by the size of the equity allocation. A higher comparative allocation to stocks will give better long-term returns, but will also increase risk. Greater bond exposure can increase costs but reduces volatility.

Alternatives to Target Date Funds

Since most target date funds are merely funds composed of other funds, any investor can create their own synthetic target date fund. It comes down to determining the proper allocation and selecting funds that match the portfolio needs. Using our asset allocation models on AAII.com as an example, a portfolio could be constructed out of large-cap stock, mid-cap stock, small-cap stock, international stock, emerging market stock, intermediate-bond and short-term bond funds (www.aaii.com/asset-allocation). Doing so allows an investor to choose the best fund for each category, as opposed to relying on the performance of a pre-specified set of funds.

Following this approach requires more involvement, however. Not only must fund performance be monitored, but the investor also needs to make allocation decisions regarding the portfolio. A strategy must be implemented for reducing the portfolio’s exposure to stocks over the long term. In addition, it is up to the investor to rebalance his portfolio when the allocation percentages for each asset class stray too far from their desired range. Failure to do so can lead to increased volatility. Finally, the investor must be willing stay with stocks—and perhaps even increase his equity allocation—during bear markets.

Supplementing Target Date Funds

Target date funds tend to follow fairly basic allocations: domestic stocks, international stocks and bonds. Only Fidelity includes specific exposure to commodity companies. None of the prospectuses I read made any mention of micro-cap stocks.

An investor seeking to include a broader range of assets should start by reading the target date fund’s prospectus to see what it invests in. (This process will likely lead to reading the prospectuses of the funds held within the portfolio.) Once this information is known, assets outside of the dominion of the target date fund can be added to increase a portfolio’s diversification. The risk of the target date fund can also be adjusted by adding more stocks (to seek higher returns) or more bonds (to produce more income) to an individual’s portfolio. Doing so, allows the investor to customize the characteristics of his portfolio while using a target date fund as his core strategy.

Charles Rotblut, CFA is a vice president at AAII and editor of the AAII Journal. Follow him on Twitter at twitter.com/CharlesRAAII.

This article originally appeared in the October 2012 issue of the AAII Journal. For the unabridged version, including the data tables, read the original article online by clicking here.

 

4 thoughts on “Target Date Funds: A Simple Premise, but Underlying Complexities”

  1. I am long time retired so I have no interest in target date funds but your article and my own analysis suggests that the practice of some employers making target date funds the default in 401K accounts a bad choice. Given the pending (?) rule on fiduciary requirements, per chance some of these employers might be trouble with this practice

     
  2. You always do a great job of explaining things. I can definitely see where you’re
    coming from and I appreciate the insight. I shared this on Facebook and
    my friends seemed to enjoy it too. Keep it up!

     

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