Target-Date Funds: Don’t Take Your Hands Off The Wheel

Target-Date Funds:  Don’t Take Your Hands Off The Wheel

Target-date funds are extremely popular with investors and are often the default choice in 401k plans.  In theory, target-date funds are a great idea; you pick the fund that matches your expected retirement date, and it takes care of details like asset allocation and rebalancing. It’s a simple option, like putting your investments on cruise control.

However, in 2008, many target-date investors discovered that instead of cruise control, it was more like driving through the markets blindfolded.   

According to a Morningstar report,  supposedly conservative  2010 target funds lost an average of 37 percent during the decline of U.S. stocks from October 2007 to March 2009.    Some 2010 dated funds lost as much as 42%.    For example, suppose you were a 63-year-old investor who was planning to call it quits in 2010. At this point in the game, you weren’t interested in taking big risks in your portfolio. You trusted your 2010 target-date fund to keep you on track. Before you knew it, 37% of your fund balance was wiped out, leaving you with precious little time to recover your losses. This wasn’t what you signed up for.

Retirement planning is a complex process that needs to be customized for each individual’s situation.  While a “one size fits all” approach sounds good in theory, the target-date data shows us that it’s not a panacea for retirement planning.   And with most of the population not yet adequately prepared for retirement, relying solely on target-date funds can be a dangerous decision.

Target-date funds were created in 1994.  Target-date funds vary in investment practices  and many have above-average annual expenses.  Some target-date funds have strange schedules that only rebalance every five years. Meanwhile, they charge fees every year, an average of 0.84%.   Most investors assume their target-date fund is doing all the work for them.  If they are rebalancing only every five years and charging fees every year, the entire proposition becomes questionable.  Mike Kane, CEO of Hedgeable Kane said, In what other industry would it be acceptable to get paid for doing work every five years? He has a point. Target-date funds are a $650 billion business. With a 0.84% average fee, that comes out to almost $5.5 billion out of investors’ pockets.

Fortunately, most target-date funds have bounced back since 2009.  However, without the proper due diligence into the fund’s inner workings, the average investor may not realize exactly how much risk they are taking. 

2008 is starting to feel like a long time ago. If another crisis occurs, how will target-date funds fare? No one complains when the market goes straight up for seven years.   However, it’s during moments of crisis and bear markets when we find out how much risk our investments really have.

There is no magic safety cushion in investing.  Your return depends on how much risk you take. Target-date funds modify their risk levels by adjusting their allocations of stocks and bonds. Risk levels are supposed to be higher when you’re younger and lower when you’re older for most people. However, from past data, we can see that some target-date funds may be overestimating the amount of risk some people can afford to take.  That’s apparently what led to huge losses in near term target-date funds in the 2008 decline.  That’s the problem…this is not an advisor who can learn about you, your circumstances, your goals and your ability to tolerate losses.  Instead it’s a one stop solution to what instead should be a very personalized thing.

Target-date funds are a tool and not a complete solution.  Investors should consult with a financial professional who is familiar with their unique life situation, needs, goals, and ability to tolerate losses. Like a pair of shoes that don’t fit, a target-date fund that does not meet an investor’s needs can cause a lot of pain. There is simply no substitute for due diligence and professional advice.

After the lessons of 2008, the message to target-date fund investors is clear: When driving on the highway to retirement, you can use cruise control on some stretches of road, but don’t ever take your hands off the wheel.