7 Ways Target-Date Funds Could Be Better

Paul Merriman  |

The target-date retirement fund is among the greatest modern inventions that benefit individual investors.

In fact, when 21st century investors count the tings for which they should be thankful, I think the target-date fund, or TDF, ranks right up there with low-cost index funds, discount brokerages, exchange-traded funds and online information sources such as Morningstar.

However, TDFs can — and should — be better than they are.

A brief background: The first TDF was introduced in March 1994 by Wells Fargo and Barclays Global Investors. Their goal was to help the operators of 401(k) and similar plans persuade participants to manage their asset allocations over time.

Despite millions of dollars and many thousands of hours spent over 20 years trying to educate retirement-plan participants, very few of those participants took the time and trouble to review their asset allocations as they got older.

Some workers made the easy initial election to put all their contributions in money-market funds, and then left them there. At the opposite extreme, others chose to have all their money in equities, and left things that way until they retired.

Neither of those approaches was wise.

After some study, Wells Fargo and Barclays Global Investors figured out that the number of years until someone expected to retire was the most powerful piece of data, more important than all the other factors.

They realized they could use that insight to organize millions of participants into groups that were roughly based on age, and then provide a lifelong strategy that would suit most investors in each group.

That strategy, which later came to be known as a “glidepath,” emphasized stock funds for younger participants and gradually shifted more of the portfolio into bond funds to reduce risk in later years, as preservation gradually becomes more important than growth.

The idea caught on. Fidelity introduced its Freedom Funds in 1996; T. Rowe Price followed in 2002, and Vanguard in 2003.

Many other fund companies also have TDFs, and millions of retirement-plan participants rely on them. They are funds of funds, meaning they don’t invest in individual stocks and bonds.

This is a good thing.

But TDFs are not perfect. Here are seven ways they could be better.

1. Managers of target-date funds should stop putting actively managed funds in their portfolios. Investing in actively managed funds drives up costs (thus reducing returns), without any realistic probability of achieving higher returns. TDFs should invest exclusively in low-cost index funds. Fund companies that believe in active management could offer two sets of TDFs: one based on passive index funds, the other based on actively managed funds.

2. TDFs that tack on extra expenses beyond those of their underlying funds should drop the additional charges, which penalize shareholders unnecessarily. These extra fees can amount to 0.5% a year, enough to cost a longtime shareholder $1 million in ultimate value.

3. TDFs should choose a more aggressive mix of equities for younger investors, giving them more opportunity for growth; as funds get closer to their target dates, the equity mix should stick more closely to broad market averages like the S&P 500 index SPX, -0.76% Because most TDFs have only one mix of equities for investors of all ages, they miss an easy opportunity to do more good for their younger shareholders.

4. Specifically, TDFs should load up on small-cap funds for shareholders who are 30 to 40 years from retirement. Personally, I believe that 20-something investors should have at least half their money in small-cap funds.

5. Additionally, TDFs should increase their stake in value stocks for shareholders of all ages. Academic research consistently shows that investors benefit from having more equities in value funds than in growth funds. This applies equally to small-cap and large-cap funds, and to international funds as well.

6. TDFs should use all-equity portfolios for younger investors. Unfortunately, most TDFs always keep a minimum of 10% of their portfolios in bond funds. This hurts young investors (every 10% in bonds reduces the portfolio’s expected rate of return by 0.5%). The rationale for bonds is that it protects investors from major bear markets.

For investors nearing retirement, this is valid. But for investors with 30 or more years to go, a bear market should be seen as an opportunity to buy more assets at discount prices. In a severe bear market, holding 10% to 20% in bonds doesn’t reduce the losses in any meaningful way.

Based on history, an all-equity portfolio will likely experience a 12-month decline of 50%. With 10% or 20% in bonds, the expected loss drops only to 47% and 44%, respectively. In return for accepting a little additional risk, the all-equity investor can expect an extra 0.5% to 1% in annual returns, as you can see at the bottom of this table.

7. Target-date funds should go one step further in segregating their target audiences. After you indicate your approximate year of retirement, you should be given a three-way choice of whether you want your investments allocated aggressively, conservatively, or moderately. Any mutual-fund company that can do that and still keep its costs low will have a winning combination.

Some investors may wish to create their own glidepaths, either within or without an employer retirement plan.

To help investors who want to manage their own target-date portfolios, we have developed a suggested glidepath that’s built one year at a time, from birth to age 65, with specific recommendations on how to balance your investments between stock funds and bond funds. You’ll find that glidepath and a related podcast here.

In spite of all these suggestions for improvements, I firmly believe that target-date funds remain a terrific tool for retirement-plan participants who want to “set it and forget it” while they live their lives fully. The majority of the alternatives are much, much worse.

Richard Buck contributed to this article.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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