The concept of target date funds seemed like a swell idea when they were introduced in the 1990s.
Beleaguered retirement plan participants no longer needed to put themselves through the head-scratching process of selecting the "correct" allocation or asking their equally clueless co-workers what funds to use.
Instead, they could outsource the decision-making to a money management company, which would rebalance the portfolio periodically and adjust the risk in the account as the participant neared his or her desired retirement age. This is sometimes referred to as a "glide path."
Conceptually, target date funds were popular enough that the government soon allowed plan sponsors to make them the default investment option for anyone who enrolled in a retirement fund. This was an attempt to combat the large number of participants who sat on cash for years because they had not selected an asset allocation.
The ease of target date funds explains why their use has exploded. According to the Investment Company Institute, a national association of U.S. investment companies, there was $618 billion invested in target date funds at the end of 2013, up nearly fourfold from $160 billion in 2008.
Still, a few problems have arisen since target date funds have matured. First, until the financial crisis and stock market crash, many participants had no idea that the risk in these could be significant. For example, the current allocation of the Fidelity Freedom 2030 Fund is 86 percent in stocks and 14 percent in bonds. For a 50-year-old who thinks she is investing in a balanced portfolio, that's an allocation that could take a big downside hit if the stock market drops.
It also should be noted that the fees for many of these funds could be steeper than index investments that are often offered alongside them. Then there is the problem of target date fund misuse. According to a recent study from Financial Engines, an independent investment adviser, many workers who are investing in target date funds are not using them as intended, ultimately lowering their investment returns.
The study found that more than 60 percent of workers who hold money in target date funds also invest in other funds, which undermines the all-in-one benefits for participants. This target-date fund misuse is hurting investment returns: The study found that, on average, workers who were partially allocated to target date funds had median annual returns that were 2.11 percent lower than individuals exclusively using target date funds.
In addition to the fees, risk and misuse, there is another reason to delve into target date funds: They approach retirement money management in two different ways. The first is called a "to" glide path, where the manager reduces risk to the lowest level on the target date of your retirement. That means that if you were retiring in 2020 at age 70, the fund would have the lowest allocation in risky assets, like stocks or commodities, and the highest in fixed assets. Mega manager BlackRock adheres to the "to" philosophy, as do many independent investment advisers, who are most concerned with downside risk for retirees.
The other management style employs a "through" glide path, which assumes you will live many years after your retirement date. As a result, the assets are invested to keep pace with inflation and often remain invested for growth. The "through" glide path aims to combat the risk that you outlive your assets. Fidelity, Vanguard and T. Rowe Price use "through" glide paths.
Michael Goodman, president of Wealthstream Advisors in New York City, encourages retirement investors to "understand the glide path your fund utilizes and how it fits into your plan and risk tolerance." While he is a bit more partial toward the "to" path, he also noted that some plans only offer the "through" version.
As a result, investors should "check in every so often on the glide path to make sure it still fits your personal time horizon."
For such an "easy" investment solution, target date funds are not as simple as they were intended to be.