Apathy and neglect can be benign forces in the investing world. Need proof? Look no further than target-date funds. These set-it-and-forget-it investments have become ubiquitous in 401(k) plans since the Department of Labor ruled in 2007 that employers could use them as a default choice for workers who neglected to pick an investment option for their accounts.
Since then, the assets in target-date funds have tripled -- and that is all to the good, say many experts. They argue that employees are getting a more appropriate mix of investments than they did with the guaranteed-interest accounts that were once the main default choice for plan participants.
But if you're one of those passive target-fund investors, you’d be wise to get up to speed as you slide toward retirement. After all, once you clock out, you’re not bound to remain in the fund your employer picked for you. And even though the funds all have the same purpose, funds with the same target retirement year can have widely varying notions of what constitutes a bull’s-eye. The closer you are to needing your savings, the more important those differences become.
Nothing illustrates the point like the actual performance of target funds when the market tanked in 2008. The 31 funds with a 2010 target date lost about 25%, on average; but some had losses as great as 41% (worse than the overall stock market’s 37% plunge), and some lost as little as 4%.
That real-life experience was a wake-up call for both investors and regulators.Congress subsequently held hearings, and the Securities and Exchange Commission tinkered with the rules to rein in some outliers and require better disclosure. But there are still important differences among the funds.
What’s true for all target funds is that they invest in a mixture of stocks, bonds and cash (and sometimes in commodities and other asset classes as well). The mix of investments varies over time, starting out with aggressive, stock-heavy allocations when investors are young and far from their target -- usually an anticipated retirement date -- and becoming increasingly conservative as investors get older and closer to their goal.
But how funds define conservative is inconsistent. Exposure to stocks -- the main cause of volatility -- ranges from 55% to 10% among funds that have reached their target date and are thus catering to those who are already retired or nearing retirement, says analyst Sasha Franger, of fund researcher Lipper.
The explanation: About 35% of target funds expect to get you to retirement; the remaining 65% expect to help you through retirement. Those just getting you to retirement assume that you’ll need the bulk of your assets right away, so they become conservative about five years before the target date. Those with a get-you-through approach become conservative far more slowly -- often over the course of another decade or two.
Ultra-cautious. Deutsche Bank's series of exchange-traded db-X target-date funds, for instance, are by far the most conservative for near-retirees. By the time these ETFs reach their dates, the allocation to stocks drops to 10%. The remaining 90% of the funds' assets are in short-term bonds and money market instruments. "If you have a target date, we assume that you have a specific event that you need your money for," says Martin Kremenstein, chief operating officer of the db-X target funds. This approach allowed db-X Target Date 2010 ETF (symbol TDD) to lose just 10.1% in 2008. However, the db-X fund earned considerably less than its rivals in 2009 and 2010, when the stock market performed well.
The db-X funds that have hit their maturity date don’t remain conservatively invested for long. A year after a fund reaches its target date, Kremenstein says, the portfolio starts shifting back into stocks. Within five years, a fund’s stock exposure will rise to 32% and remain there, he says. That’s the level that Deutsche Bank managers think is right for a conservative long-term portfolio.
Why the reversal? DB figures that people who leave their money in the target fund for more than a year after retirement probably don’t need the cash immediately. So even though the original intent was to get you to retirement, the money that stays will be invested through retirement.
By contrast, T. Rowe Price has a large stock position at the target date -- some 55% of the portfolio. Over the next 20 years, the fund company will ratchet stock-market risk down to 20% before the fund’s so-called glide path levels out.
This aggressive approach is based on two assumptions. The first is that investors won't take a lump sum and run, that they’re more likely to withdraw assets slowly over a course of 20 to 40 years in retirement. The second is that a short-term loss isn’t the worst risk that investors face in retirement, says Jerome Clark, manager of T. Rowe Price's target-date funds. The bigger risks are longevity and inflation, which could cause investors to run short of money before they run out of breath, he says. By keeping the portfolios more heavily invested in stocks during the early retirement years, the funds’ returns are more likely to beat inflation and provide more buying power for retirees later on. “It’s uncomfortable to lose money early in retirement, but it’s devastating to run out of money 20 years later,” Clark says. “We would rather that our investors be a little more uncomfortable during a market like we had in 2008 to better protect them from what we consider to be bigger risks.”
Middle path. Both Vanguard and Fidelity -- the industry's two top players -- fall somewhere in the middle. Both have glide paths that would have investors at about 50% in stocks at retirement. Both gradually move assets into a more conservative mix over the next several years. At the point that the fund managers stop making age-related adjustments -- at about seven years after the target date for Vanguard and 15 for Fidelity -- they automatically shift investors who remain with their target-date fund into retirement-income funds. Such funds typically have only a modest allocation to stocks and invest the bulk of their assets in fixed-income products and commodities to protect against inflation.
For investors, the best advice is to consider what you need from a target fund. If you're more worried about market volatility than long-term returns, look for a fund with a conservative mixture of assets from start to finish. If you can handle some volatility, look for a fund that’s more aggressive.