Understanding the Risks of Target-Date Funds

(photo: iStockPhoto)

The Securities and Exchange Commission proposed new regulations for the marketing of target-date retirement funds (TDFs) recently — a development that, more likely than not, escaped most investors’ attention.

But if you are among the millions of Americans who own a TDF, understanding the reasoning behind the new rules could actually help you figure out whether these funds are the right product for you.

It all began in 2006, when Congress allowed companies to automatically enroll employees in 401(k) plans and made TDFs an acceptable default investment option. In short, Congress told companies that they could put their employees’ retirement savings into TDFs without getting sued. Money poured in. As of March 2010, according to the SEC, TDFs held $270 billion in assets, most of which has come in since 2006.

TDFs were invented in the 1990s and are designed to simplify investing. They have names like Fidelity Freedom 2030 (FFFEX) or American Funds 2010 (AAATX), and the idea is for investors to choose the fund with a date closest to their retirement date. The funds start out heavily invested in riskier, but potentially higher-return assets (such as stocks and real estate investment trusts) and, as the target date approaches, they increase their exposure to less volatile assets (such as bonds and cash).

Ramit Sethi, author of I Will Teach You to Be Rich, is a big TDF fan. “Most people believe, mistakenly, that they’ll be disciplined enough to be a great investor, buy low and sell high,” he says. “When decades of evidence have shown that, in fact, we do the opposite.” Target-date funds solve that problem — and go even further to address, for lack of a better word, the “investing high” crash so many investors experience.

“You may be excited about investing right now—you might even buy a couple good books—but three months from now you’re not going to give a damn. And yet your target-date fund will silently be chugging in the background, taking your investments and properly allocating them where they need to go,” Sethi says.

If you’re a regular reader of my column and are getting tired of my shtick, you will be disappointed to learn that I own shares of Vanguard Target Retirement 2040 (VFORX). The fund currently holds 90% stocks and 10% bonds. Twenty years from now, it will ease back to 68% stocks and 32% bonds, and on the target date, 2040, it will hold 50% stocks and 50% bonds. This change in allocation over time is referred to as the fund’s “glide path.”

The problem is, the majority of TDF glide paths don’t wind down to an allocation entirely devoted to bonds and cash. Many investors became painfully aware of this fact in 2008.

The big crash

In 2008, the stock market had one of its worst years ever: the Dow Jones Industrial Average was down 36% and the S&P 500 fell 41%.

The average 2010-dated TDF lost 24%, according to the SEC, and investors who thought they’d be in safe assets that close to their target date were, let’s say, unpleasantly surprised.

“We use the term glide path,” says Ron Surz, the president of Target Date Solutions and a fund manager at the SMART funds family of funds, which are set up to be 100% invested in U.S. treasury securities and cash by the time a fund’s target date rolls around.

“My view is that if you’re coming into the airport at 20 feet above the ground – 20% in equities – that’s not a safe landing,” Surz says.

The SEC has the power to regulate the composition of TDFs, but they’re not wielding it. Instead, they’ve focused on marketing: before someone invests in a fund, they’ll have to look what the SEC calls “graphic depictions of asset allocations” (do you get the sense that someone at the SEC has been watching late-night Cinemax?) showing exactly what the fund will be invested in on the target date and what it invests in today.

To Zvi Bodie, professor of management at Boston University and author of many books on investing and retirement, this doesn’t go far enough. “The damage is done by the name of the fund,” he says. “The name is inherently misleading. They have nothing whatsoever to do with target dates. Nothing happens on the target date. Nothing is promised on the target date. So why call them target date?”

In defense of TDFs

These criticisms ignore several key points, says Joshua Grandy, a spokesman for Vanguard, one of the leading providers of target-date funds. First, he says, most investors understand the risks inherent in the funds. “In a recent Vanguard survey of TDF investors,” he said via email, “some 93% acknowledged the risks of target-date funds. Less than 1% indicated that target-date funds carried no risks at all.”

Second, the question isn’t whether TDFs are perfect, but whether they’re better than what investors do without them. Vanguard found that, in the absence of a TDF option, over half of investors put themselves in an extreme position: 100% stocks or no stocks.

Finally, according to Vanguard (and most other TDF providers), a “safe landing” is inappropriate because TDFs are designed for continued growth during retirement; they’re not meant to be cashed out when the investor turns 65. And Vanguard has found that only a minority of investors tap their retirement accounts before age 70-1/2—if the market goes south at the target date, those retirees have time to recover their losses.

SMART Funds’ Surz thinks these points are irrelevant. “Much of the reason for landing safely is psychological,” he says. “You might very well be wealthier with a glide path that increases in equities rather than decreases, but the exposure you’re going to give yourself at the time when your balances are the largest is something you need to think about before you do it.”

It’s all about risk

The debate over target-date funds began long before the funds existed, because it’s really the old debate about how much risk the average investor should take.

Proponents of investing in risky assets argue that the biggest risk in retirement savings is outliving your money; investing in assets with high growth potential (stocks) is essential to beat inflation and earn an adequate return; and over the long term, the risk of losing money in stocks is low.

Conservative investors reply that savers who are willing to start early and put aside a reasonable amount each year into boring, low-return investments like treasury bonds can hit their retirement goals without worrying about their savings disappearing into a black hole the day before retirement. Also, they say, stocks don’t get any less risky over time: the percentage you might lose goes down, but the dollar value goes up.

Sethi points out that there’s a middle path. “You can also balance your target-date fund,” he says. “If you say, ‘You know what? I’m not disciplined enough to rebalance my portfolio, so I’m going to put a majority of my money into a target-date fund. But just to be safe, I’m going to keep an extra 10% in a savings account and never touch it.’ ”

CORRECTION: An earlier version of this story referred to 2008 performance of the SMART Funds; those funds weren’t created until November 2008.

Matthew Amster-Burton, author of the book Hungry Monkey, writes on food and finance from his home in Seattle.