By Andrew Farrell
Don’t be fooled by the booming popularity of target-date funds. Poor performance, improper asset allocation and high fees have marred many of these mutual funds. They’re more likely to bring you headaches than outsized investment returns.
Their Pitch For Target-Date Funds
The pitch for target-date funds is straightforward: “How would you like to simplify your retirement investing? Just pick the fund that matches the decade when you plan to retire. You don’t have to worry about changing your mix of investments as you get older. We, the mutual fund company, will tailor the asset allocation and portfolio aggressiveness to the time before your target retirement date.”
In other words, these funds will make retirement planning more like a happy retirement. It’ll be less work and worrying about the small stuff. As we all know though, few things in life are that easy. And the financial turmoil of the last few years showed that target-date funds have serious problems.
The Back-Story of Target Date Funds
Before we get to the problems, let’s take a few steps back and look at the rapid ascension of target-date funds. According to Morningstar, target-date funds had a net $7 billion inflow in 2003. By 2007, the inflow was $57 billion.
What happened? Many employer-investment plans automatically start a worker’s retirement savings in these funds. In 2009, the U.S. Senate Special Committee on Aging found that 96% of companies that use automatic enrollment features have chosen target-date funds as the default. 
For a while, this seemed like a win-win. Workers had their money steered into a mutual fund that was supposedly tailored for their retirement timeline. Mutual fund providers had a hot new product.
But the financial crisis that erupted in 2008 revealed target-date funds weren’t living up to their pitch. Not surprisingly, these funds went south that year like almost all investment vehicles. What was surprising was how poorly some supposedly conservative target-date funds fared.
Take the performance of the 2010 target-date funds during 2008. With 2010 as their target date, these funds were aimed at people with retirement just two years away. It doesn’t take a financial advisor to know that these funds should have their money allocation heavily biased towards very conservative investments with low risk. The funds should avoid heavy losses.
Many didn’t. Morningstar’s 2010 Industry Survey gathered the 2008 returns of 27 funds with a 2010 target date. All but one lost more than 10% during that year. Oppenheimer’s Transition 2010 fund fell by 41.3% in 2008. In the same year, Alliance Bernstein’s 2010 Retirement Strategy Fund dove by 32.9% and Goldman Sachs’s Retirement Strategy 2010 Fund lost 30.8%. 
Part of the problem was that many of these target-date funds weren’t allocating assets as the investors expected. The mix of stocks, bonds, and cash for many 2010 target date funds wasn’t appropriate for their investors who had plans to retire soon.
Equities, generally considered a more aggressive and risky investment class, accounted for as much as three-quarters of the assets in some of the target-date funds. Compare that to the Dow Jones Target-Date Indexes’ suggestion that a fund should have only about 28% equities exposure when it reaches its target date. 
In other cases, target-date funds nearing their target date have been found holding high levels of junk bonds. These bonds have higher yields but also have a much higher risk of default than government or “investment grade” corporate bonds. While junk bonds are far from ideal investments for most nearing retirement, some of the funds have surprisingly high exposure to them. For example, John Hancock’s Lifecycle 2010 mutual fund had 35% of its debt holdings in junk bonds at one point in 2009, just a single year removed from its target date. 
There’s another facet of target-date funds that investors should be aware of. When the Senate Committee on Aging decided to take a closer look at target-date funds, they didn’t just find a problem with varying asset allocation. They spotted a problem with the fees these funds charge. A report from the Committee included data from 401(k) ratings firm Brightscope that showed target-date funds have internal fees 10 to 25 percent higher than other 401(k) plans. 
The structure of target-date funds contributes to this disparity. Many of them are “funds of funds,” investment vehicles that invest in other funds instead of securities directly. In some cases, this creates two layers of fees. The fund of funds gets the first layer and the funds that it invests in get the second layer. 
What This Means For You
In a perfect world, target-date funds would simplify investing for retirement by offering investors asset allocations ideally tailored to their planned retirement date. Unfortunately, the mutual fund managers often use inappropriate investments, construct poorly performing funds, and charge higher fees than are necessary. Any one of these issues makes target-date funds less attractive in practice, but the worst target-date funds exhibit all three flaws.
If you’re going to invest in target date funds, it’s critically important that you research and monitor the component funds that make up the target-date fund. You want to make sure that the funds inside are appropriate given your risk tolerance and that the fund manager isn’t stuffing their target-date funds with their poorly performing funds.
In addition, you want to make sure that the target-date fund you’re researching isn’t charging more in fees than you could get by constructing a similar basket of funds yourself. Even small increases in fees and expenses can have a dramatic effect on the value of your investments when you withdraw your funds, either at retirement or to fund your other goals. Make sure you minimize your fees so that you get the maximum value for your investment dollar. http://www.aging.senate.gov/letters/targetdatecommitteeprint.pdf (PDF link)  http://corporate.morningstar.com/US/documents/MethodologyDocuments/MethodologyPapers/TargetDateFundSurvey_2010.pdf (PDF link)  http://www.aging.senate.gov/letters/targetdatecommitteeprint.pdf (PDF link)  http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aXE4c8hMe.Kw  http://www.aging.senate.gov/letters/targetdatecommitteeprint.pdf (PDF link)  http://www.gbophb.org/sri_funds/articles/TargetDateFund.asp