Bobby Moyer, CFA, CFP®, CAIA Chief Investment Officer
The Good
Over the past decade the U.S. Target-Date mutual fund category has grown from under $200 billion in assets to over $880 billion as of the end of 2016. These types of investments address the “misallocation” risk that many 401(k) plan participants suffer from. Many financial advisors tout these strategies as the “easy solution” for a plan participant that understands he needs to save for his retirement but does not want to spend too much time deciding how to invest his savings. Target-date funds are invested in a general manner consistent with individuals who will retire at a retirement age in their mid-sixties. Target-date funds start off in an aggressive allocation but automatically shift to a more conservative structure as you approach retirement. This is very easy and is a “set it and forget it” strategy. Because of these characteristics they are good.
The Bad
Unfortunately, target date funds are not perfect. One of the biggest drawbacks to using target date funds is that often times the underlying investments are proprietary funds of the fund family offering the fund. Even the best fund families struggle to be competitive in certain asset classes. A fund family may include smaller and underperforming funds in a target date fund to make the fund profitable to the fund family. Because of not being able to use “best-in-class” funds, this a bad characteristic.
Maybe the Unknown
Not all target date funds are created equal. Because target date funds are often described by retirement plan advisors as “the easy button” of retirement plan investing or the “set it and forget it option,” target date funds are often misunderstood. Target date fund providers often choose between the “to retirement” or “through retirement” approach to manage these funds. The “to retirement” approach moves the investment allocation to a more conservative approach at retirement age of say 65 or 66. The “through retirement” approach is more aggressively positioned at retirement and becomes more conservative through retirement. The belief with this approach is that the participant still has many years left to live after reaching normal retirement age and the portfolio will need to support them through these non-working years. Because of these differences, performance will be much different between similarly named target date funds. A fund using the “to” approach should perform better in down markets and worse in up markets assuming the current year is near the retirement year in the fund’s name. The farther away from retirement, the less significant this issue, since both types will be relatively aggressively positioned. Where these funds could cause some issues is when an investor is nearing retirement and he believes he is conservatively invested but in actuality, he still may be 50 percent allocated to stocks. A portfolio with this structure may still suffer absolute declines that could reach 10 to 20 percent or more if broad equity markets suffer significant declines. For instance, the Morningstar Category Average for the US Active Fund 2000-2010 return for 2008 was -24.82 percent. If investors are uninformed, suffering these drops near retirement may cause a knee-jerk reaction to sell at an inopportune time. It should be noted that many financial advisors would educate their clients to continue to have some equity exposure near retirement since these funds must last several decades and the equity exposure will provide a hedge against inflation and provide some growth opportunities.
Another Similar But Different Alternative
An alternative solution that some retirement plan advisors could implement in investment plan lineups is the use of asset allocation models or lifestyle funds. Both options create investments that focus on a risk profile, not a retirement age. One advantage to using this approach is that if an investor thinks he is being conservative, he is invested in a conservative manner, which may prevent knee-jerk investment decisions because the current investment was misunderstood. The negative is that an investor may need to be more active, meaning he needs to adjust his allocation periodically to move to a more conservative allocation over time. This will not automatically be done for him. When using asset allocation models created by an advisor, you may be using best-in-class funds for each asset class, as opposed to proprietary funds used by many target date funds and other lifestyle funds.
The evolution of the retirement plan investment options has been an overall positive progression for the industry. However, it has not replaced the need for plan sponsor and participant education. Plan sponsors have a responsibility to be educated on the different types of target date funds and which approach is best for their company. Additionally, plan participants should not take a blind approach to retirement investing. They should at the least be slightly educated on what they own.
ACG has been educating plan sponsors and plan participants for decades on the pros and cons of different investment options. If your plan needs a checkup on the investment options being offered, please contact us to set up a meeting.
Other posts you may be interested in:
Why a Strategic Asset Allocation is Important
Chasing Performance When Choosing Mutual Funds Can Be a Big Mistake
