“No other fund of any flavor has attracted so much criticism, and no other type of equity mutual fund has sold so well in recent years.”
-Morningstar Target-Date Series Research Paper, 2010 Industry Survey
Target-date funds have exploded onto the investing scene like a juggernaut. The statistics are impressive, or perhaps, alarming, depending on your point of view:
- Target-date funds have grown more than 700% since the end of 2005, from $71 billion to an astronomical $508 BILLION dollars by the end of March 2013, according to Morningstar Target-Date Series Surveys.
- Vanguard reported the end of 2011 that 82% of its retirement plans offered target-date funds, and nearly one-fourth of participants invested ONLY in a target-date fund.
- In a 2012 “How America Saves” report, Vanguard says that 47% of defined-contribution participants were invested in a target date fund, up from 18% in 2007.
- Consultant Casey Quirk estimates that target-date funds will represent more than half of all defined-contribution assets by 2020.
Still growing in popularity by nearly 15% per year, target-date funds have become the mainstay of the mutual fund industry and continue to attract money like a magnet, regardless of performance, market conditions, SEC hearings, or criticism (which has been significant, even in the normally unquestioning financial publications).
What exactly are target-date funds? Where did they come from? Should we be excited or very, very afraid of this powerful financial trend? What issues should be considered by anyone interested in target-date funds? What are the alternatives?
We’ll tackle these questions and more in this series on target-date funds. In this, our first installment, we’ll give some history and background.
Target-Date Funds 101
Also known as Lifecycle funds, age-based funds, or simply TDF’s, target-date funds are hybrid mutual funds comprised of a mix of stocks (typically other mutual funds), bonds, cash equivalents, and occasionally other assets. Designed as “set it and forget it” funds, they are aimed especially towards investors who aren’t sure where to put their money or what to invest in (which covers a LOT of investors.)
What makes them “target-dated” or “age-based” funds is the fact that their asset allocation is adjusted over time to become more conservative as the target date (usually representing retirement) approaches. The formula that determines the changes in a fund’s asset allocation mix is referred to as its “glide path.” (Not coincidentally, the term also invokes visions of investors “gliding” into a smooth transition from nest egg accumulation to disbursement.)
The goal of target-based funds is this: they aim to be more aggressive to achieve growth (with admitted risk and exposure to market whims) while investors are younger and further from an estimated retirement date. Funds are typically weighted heavily in stocks (in the form of other mutual funds) during earlier “growth” phases.
Then, as investors age, the asset allocation mix changes to reduce their exposure to market fluctuations and focus more towards income generation (at least theoretically). As anticipated retirement dates approach, most (but not all) target-based funds shift the majority of their holdings into bond-based funds and cash equivalents, thus, lessening volatility and increasing stability.
However, theory has not always matched reality where risk reduction – or growth potential – is concerned. Just because you choose a fund within 5 years of a retirement date – or even past a targeted retirement date – does not mean that the majority of your money WON’T be in the stock market.
For instance, of the industry’s market leaders, T. Rowe Price, maintains a majority position in equity exposure even into retirement years. (Asset allocation mixes and glide paths vary significantly from company to company, making it difficult for investors to understand what they’re getting.)
A Brief History of Target-Date Funds
The first TDF’s were introduced just over 19 years ago, in March of 1994 by Wells Fargo and Barclays Global Investors (the two firms had some departments in common back then.) In October of 1996, Fidelity rolled out their Freedom Funds. They were followed by Nest Egg in 1999, Principal in 2001, T. Rowe Price in 2002 and Vanguard in 2003. More followed.
The funds were created partially in response to market demand by participants in self-directed defined contribution plans; e.g., 401(k) participants. As Target Date Analytics describes in “A Brief History of Target-Date Funds,”"As anyone who ever conducted an employee investment education meeting knows, at the end of all the sincere charts and presentations, investors would approach the meeting leader and say, ‘I understand all that allocation and risk-return stuff, but would you just tell me what to do?’ ” Thus, target-date funds were born.
The Pension Protection Act of 2006 set the stage for explosive growth, allowing employers to enroll their employees in target-date funds automatically. Shortly after the Pension Protection Act created a need for QDIA’s, or Qualified Default Investment Alternatives, the mutual fund industry successfully lobbied decision-makers to make target-date funds a new default investment option. The former default, stable-value funds (insurance-wrapped bonds with a conservative guarantees of performance) were eliminated as the default option.
Marketed as the all-purpose, all-inclusive investment option, target-date funds quickly became the favorite default option of both employers and employees. Additionally, in 2007, the Department of Labor granted target-date funds “safe harbor” status by guaranteeing employers can never be sued for placing employee funds into target-date funds, even if the investments lose money.
The result? The safe harbor “unleashed a flood of money into the funds,” as summarized in The New York Times in “Target-Date Funds May Miss Their Mark.”
The “Success” of Fast-Food Finance
Why so popular? Are target-date funds recommended by top fee-based advisors? Do they have a long and reliable track record? Have they performed well in good times and bad? The answers are “no” on all accounts. Then, how has this relatively “new kid on the block” with a questionable track record taken over the neighborhood?
It’s EASY and AUTOMATIC to end up in a target-date fund. Like falling down a hill, it’s easier to start investing in one than not! Target-based funds are now the default option for a majority of 401(k) programs. This fact, combined with automatic enrollment into retirement plans (employees must typically opt OUT if they DON’T wish to be enroll in a 401(k) plan), explain why so many Americans “choose” target-date funds.
“Simply enter in the year you’d like to retire (or if you don’t know that, your birthday will suffice), and all the hard work of asset allocation and risk management will be done for you. All you have to do is sign here – wait, never mind, you don’t even have to sign anymore! Your employer can automatically sign you up for your retirement plan.”
It’s SIMPLE and QUICK. Making investment choices has never been so… convenient. Just like fast food drive-ins offer meals to make it easy to order a dinner in fifteen seconds or less (though not a very healthy or balanced dinner), so target-date funds make investment choices simple and quick. Just check a box. (Or do nothing.)
“No need to hire a financial advisor, do any research or make any complicated decisions; the experts have already done that for you! Go ahead and check ‘financial planning’ off of your to-do list. Now you can get back to planning something more complicated, like your next vacation.”
And EVERYBODY’s DOING IT. You’re sitting in front of an HR person, your company’s 401(k) administrator. They think it’s a good idea. Congress says it’s a good idea. The Department of Labor says it’s a good idea. Some expert somewhere is managing the fund. And millions of other investors have already chosen the same path. What could possibly go wrong!? The power of these implied endorsements cannot be underestimated.
Target-Date Fund Failures
A tremendous coup for fund firms, which allowed mutual funds to be packaged and sold in a new form (generally with an additional layer of fees), target-date funds have been less successful from an investor standpoint. The 2008 market crash revealed that many did not function as advertised. Intended to dial down risk for investors nearing retirement, the average funds with a target date of 2010 lost a shocking 23% in 2008, according to Consumer Reports.
As reported by CNN Money, Vanguard Target Retirement 2010 and Fidelity Freedom 2010, funds for investors just a few years from retirement, lost about 26% and 29% of their value, respectively, in 12 months. One small fund run by Oppenheimer Funds fell almost 45%.
Clearly, if consumer protection was a goal of target-date funds, many of the funds had fallen horribly short of the mark. Financial analysts, normally partial to all things Wall Street, sounded off alarms. The SEC launched a Congressional investigation. And yet, a funny thing happened after the crash of 2008 revealed that market-date funds were simply an old pig in a new color of lipstick:
Money just kept pouring in.
Aided by the new robo-investing practices and legislation, investors (particularly younger investors who were newer to the job market) continued to be automatically enrolled in target-date investing schemes.
The SEC recommended that firms be more revealing as to where investor’s dollars were actually going, which has happened, to a fair degree. Recommendations were even suggested to require fund managers to act under a fiduciary platform (putting investor’s best interests ahead of their own), which was met with predictable resistance and has not been adopted into practice. But like a steam train, little has slowed the growth of target-date funds.
How have target-date funds performed since the crash? Again, performance has been underwhelming. According to a Huffington Post article, “Performance can be lackluster. The average fund with a 2015 target date posted a loss in 2011, a year in which the Dow Jones industrial average as well as bonds delivered gains.”
A tremendous success story for money managers, from an investor’s point of view, target-date funds represent a dangerous trend. These funds have exploded from a new type of fund to a market-favorite monster in less than 20 years. This is not necessarily good news for American investors who prefer to have someone manage their money for them. Too many are sold on strategies that may not ultimately serve their best interests, that they don’t fully understand, or that may even be misrepresented to them.
For investors willing to educate themselves, there are alternatives that will help them build wealth safely and reliably, with no Wall-Street-fueled conflicts of interests. We invite you to continue to explore this essential topic with us over the next weeks. Your wealth may depend on it.
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