Do Target-Date Funds Hit the Target for Retirement Savers?

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Investors assets held in target-date funds reached a record of $1.44 trillion at the end of 20171 up 30.5% from the end of 2016. The primary reason for the increase has been cited as the fund’s popularity as the default investment option for employer sponsored defined contribution plans such as 401(k) and 403(b)s. Experts say target-date funds are the primary default investment attracting nearly 50% of new assets into these retirement plans.

What is a Target-Date Fund?

A target-date fund seeks to grow assets over a specified period to a targeted time when the assets will be needed, such as retirement. The funds are also known as lifecycle or age-based funds. The asset allocation of the fund internally mixes several different types of stocks, bonds and other investments with the objective of gradually becoming more conservative as the target date approaches. Target-date funds are usually named by the year in which the investor plans to begin using the assets.

The asset allocation of a target-date fund is on autopilot to change based on the specified timeframe available to meet the targeted investment objective. The allocation may begin at 80% stocks to 20% bonds when the target date is 30 years away and shift gradually to perhaps 30% stocks and 70% bonds as the target date approaches.

Target-date funds were first introduced in the 1990s. Vanguard Group started offering the funds in 2005 when only 2% of employees in their covered plans participated. Today over 90% of their employers offer them and 75% of plan participants are using them. Half of those participants invest their entire account in one target-date fund.

Why all the interest in target-date funds? Primarily because they are simple and easy. The participant makes one decision and can forget about it until retirement. The investor does not have to pick funds and develop an allocation or monitor it and make changes. The target-date fund does that for them internally.

Financial planners had hoped this set-it-and-forget-it approach to retirement savings would make plan participants better investors by avoiding the tendency to try timing the market. According to research by Morningstar, that does not appear to be happening. Morningstar calculated five-year investor returns for 154 of the 227 available target-date funds. Investors failed to capture the fund’s return in all but eight of the funds. Investors gave up an average of 0.83 percentage points a year2. The underperformance is caused by investors moving in and out of the funds to time the market.

A fund that is basically running on autopilot would also be expected to be very inexpensive to operate. The average expense ratio of 227 retirement target-date funds with at least $100 million in net assets was 0.67%3. The expense ratio is high in today’s environment where many ETFs charge less than 0.10%. Adjusting the portfolio annually would justify a higher expense over a static index fund but is it worth an additional 0.5%? Another important question would be whether the allocation should be adjusted at all, and if so, how often?

Investing in a static allocation of 60% stocks and 40% bonds would offer lower internal expenses over the average target-date fund. An investor who buys into the target date philosophy could simply manually adjust the portfolio periodically.

There is also a question of the right allocation. What is the correct allocation 20 years from retirement? What is the correct allocation at retirement? The answer appears to differ greatly even among target-date funds themselves. A quick review of target-date 2020 funds found stock/bond allocations varied greatly. From 60% stocks, 40% bonds in the Principal LifeTime 2020 Fund (PLWIX) to 22% stocks, 78% bonds and cash in the Putnam Retirement Ready 2020 Fund (PRRNX)4.

Unfortunately, there isn’t a “best” strategy that applies to every situation. The asset allocation between stocks and bonds will depend on a retiree’s other sources of retirement income – Social Security, pension, part-time wages, etc. – and the withdrawal rate needed from investments. Asset allocation has a more meaningful impact on the sustainability of retirement income when investable assets produce a sizeable amount of income. When more than 50% of retirement income is being produced by investments, asset allocation is critical to assure income grows to keep pace with inflation.

One of the most important questions is how long retirement will last. A 65-year old couple has a 50% chance that one of them will live to age 945. That is nearly 30 years of living in retirement. Can a portfolio of 22% stocks, 78% bonds and cash last 30 years and keep pace with inflation? Given life expectancy projections, do target-date strategies that vary asset allocations from 80/20 early in a career to 30/70 or even 20/80 at retirement make sense in today’s 3% interest rate environment? Ideally, assets will be broadly diversified to give the portfolio exposure to investments currently in favor. Portfolios should be rebalanced periodically to maintain the allocation and avoid becoming over-weighted in any one asset class.

There are reasons to applaud the interest in target-date funds. Prior to their offering, many plan participants would default to saving in the plan’s money market fund. Having exposure to stocks through a target-date fund has probably helped the average plan participant’s return. However, expense ratios need to be lower on the average fund. Allocations need to be reviewed to assess whether the target allocation at retirement is one that can sustain an income over a 30-year retirement.

Have more questions about target-date funds and retirement? Get in touch with one of the financial planners at Rodgers & Associates to see how we can help.

Rick’s Tips:

  • A target-date fund is a fund that seeks to grow assets over a specified period to a targeted time when the assets will be needed, such as retirement.
  • Today over 90% of employer plans offer target-date funds and 75% of plan participants are using them.
  • The asset allocation between stocks and bonds will depend on a retiree’s other sources of retirement income and the withdrawal rate needed from investments.

Target-date funds the engine powering continued growth.  By Meaghan Kilroy, July 23, 2018. Pensions & Investment.

Target-Date Funds Aren’t the Retirement Bull’s-Eye. By Nir Kaissar, July 18, 2018. Bloomberg News.

3 Are target-date funds the answer? July 21, 2018. The Mathematical Investor.

4 Source: Steele Mutual Fund Expert

5 Society of Actuaries RP-2014 Morality Table projected with Mortality Improvement Scale MP-2014 as of 2015.

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