As I wrote recently, target-date retirement funds are among the greatest modern financial inventions that benefit investors.
But they’re not perfect, as I’ll outline here. This is the second of three articles in which I will outline a life-long two-fund, low-cost strategy that is likely to generate terrific long-term returns.
In the first article, I wrote: “For investors who want to make a single investment decision that is likely to serve them well the rest of their lives, a target-date fund is a terrific product.”
However, target-date funds don’t go the whole distance in taking care of investors. In this article I’ll outline five ways they fall short.
In the third article, I’ll outline some dynamite ways to overcome these shortcomings.
Before I discuss how target-date funds let investors down, it’s valuable to understand how much this matters.
Vanguard is by far the largest player in this market, with almost 40% of all the assets in target-date funds, and more than the second, third and fourth largest providers combined.
According to Vanguard, roughly half of all 401(k) retirement plan participants have their entire accounts in just one target-date fund as their default investment strategy.
In other words, American workers are relying very heavily on these funds for their futures. It’s not a tremendous stretch to say that the target-date fund has taken the place once held by the company pension.
For an investment product that’s not yet 25 years old, that’s pretty amazing.
The first target-date fund was introduced in March 1994 by Wells Fargo and Barclays Global Investors, with the goal of helping investors manage their asset allocations over time.
These funds were seen as the solution to a problem: As corporate pensions fell by the wayside and individual investors were increasingly effectively required to make their own decisions inside 401(k) plans, most participants in those plans made an initial decision and never reviewed their allocations over time, even as their tolerance for risk evolved.
Some left all their money in “safe” options like money-market funds, therefore getting very little return. Others put all their money in equities and left it there until they retired. Neither of those approaches was wise.
Wells Fargo and Barclays Global Investors determined that the number of years until someone expected to retire was the most powerful piece of data with which to organize participants into groups roughly based on age, and then provide a lifelong strategy that would suit most investors in each group.
The target-date fund caught on quickly. Fidelity introduced its Freedom Funds in 1996; T. Rowe Price followed in 2002, and Vanguard in 2003.
With estimated total assets in the trillions of dollars and being the default investment choice of millions of American workers, target-date funds are much too important to ignore.
Here are five ways they fail to live up to their promise.
ONE: By far the most important drawback of target-date funds is their failure to give investors significant access to some long-established equity asset classes with superior long-term track records.
Specifically, target-date funds have only minimal exposure to small-cap stocks and value stocks. Yet these asset classes over the years have consistently achieved significantly higher long-term returns than the large-cap blend asset class that makes up more than 75% of the equity part of the typical target-date fund.
As a result, long-term investors who think they have a full portfolio in fact miss out on returns that could literally double the amount of money they have during their retirement years.
Personally I believe 20-something investors should have at least half their money in small-cap funds. Target-date funds don’t give them any option even remotely close to that.
To see how much long-term difference that real diversification can make, check out this article, which shows historical returns from a simple four-fund portfolio. (Note in this case that the equity returns of target-date funds are likely to be closest in this comparison to those of the large-cap blend asset class.)
Measured over 15-year and 40-year periods, which should be of the greatest interest to most retirement plan participants, the four-fund combination left the large-cap blend fund behind.
If you want to see some of this evidence for yourself, you’ll find it here.
If a target-date fund invested even one-third of its equity assets that way, it would do its shareholders a tremendous favor.
The tables showcase the high past returns of large-cap value and small-cap value stocks. This evidence is known to the mutual fund companies, and they could easily put it to work for the benefit of their target-date shareholders. But they don’t.
TWO: There’s little disagreement that young investors can afford to take more risks than older investors and have ample time to reap the likely long-term rewards of doing so. Yet target-date funds use the same mix of equity asset classes for all investors regardless of their age.
As we saw, small-cap and value stocks can make a huge positive difference over the long haul.
Target-date funds account for shareholders’ different needs only by gradually adjusting the portfolio’s exposure to equity funds. They could easily do the same by adjusting the mix of equity assert classes. But they don’t.
THREE: Target-date funds treat their shareholders as if the only thing that matters is their age. This is effective up to a point, and it’s certainly convenient for fund companies.
By lumping everybody of a certain age into a single pool, target-date funds wind up with the appropriate mix of assets for only some of their shareholders, not all of them.
Some people are inherently adventurous (aggressive) and others inherently more skittish (conservative.)
Mutual fund companies could easily design three 2050 funds, to take one example: one for investors who prefer an aggressive approach, one for those who see themselves as moderate, and a third for investors who regard themselves as more conservative.
For investors willing to invest a little time and thought, this can be overcome easily, as we will see in the third article in this series.
The good news is this: All it takes is the addition of a single fund to accompany the target-date fund in your portfolio.
FOUR: Target-date funds don’t own individual stocks and bonds. They are funds of funds. Each of these underlying funds has expenses that shareholders must pay. Yet some target-date funds add an extra level of expense – essentially a markup without any benefit to shareholders.
This makes about as much sense as a grocer charging a customer extra for walking out with multiple items in a single shopping bag.
FIVE: In most target-date funds, the underlying assets are low-cost index funds. But many target-date funds include actively-managed funds, which add higher expenses without any reliable expectation of higher returns.
The extra fees can amount to 0.5% a year enough to cost a longtime shareholder $1 million in ultimate value.
This is clearly a disservice to target-date shareholders.
As I stated, my next article in this series will present a simple and easy two-fund solution to these problems.
For some more of my thoughts on the shortcomings of target-date funds, check out my podcast.
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Richard Buck contributed to this article.
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