By David Gratke
Learn more about David on NerdWallet’s Ask an Advisor
When investors choose target date funds, they don’t necessarily get what they think they ordered. In fact, different funds with similar names and identical target dates have wildly different allocations – and results. It helps to look deeper into the fund prospectus and ask questions before buying one of these investment products.
A target-date fund or age-based fund is one whose asset allocation mix becomes more conservative as the investor nears his or her target date for retirement, shifting from a stock to a bond concentration. These were first introduced in the early 1990s, and grew in popularity in recent years.
According to the Securities and Exchanges Commission, TDFs held approximately $485 billion at the end of 2012, up 29% over the previous year. Roughly 70% of U.S. employers report offering target-date funds as their default investment option for company sponsored defined contribution plans. The Wall Street Journal found that 51% of defined contribution plan participants used TDFs and 23% of 401(k) accounts had more than 90% of their assets in these funds.
But not all target-date funds are created equal, and it could be very difficult for savers to pick the right ones. As retirement plan attorney Ary Rosenbaum writes, target date funds have no labeling requirements, and it’s hard to figure out what names like “2025” really mean.
For example, if you plan to retire in 2010, Rosenbaum says, you might have selected a 2010 target date fund, assuming that it moves completely toward safe fixed income investments by that point. But those 2010 TDFs lost nearly 24% in the financial crisis of 2008. Some lost as much as 41%, leaving retirees scrambling, while others lost just 9%.
How can two funds with the same retirement target perform so differently? The mix of stocks and bonds can vary greatly between two funds with the same label. It’s like two brands of diet soda that have completely different calorie counts. You reasonably expect both to be low in calories, but the soft drink companies have their own calculation for that.
“Two funds with the same target date don’t necessarily have the same proportion of stocks and bonds—but barely half of people who own target-date funds realize that fact,” says Rolf Wulfsberg, global head of quantitative research at Siegel+Gale, a strategic branding firm, which conducted the SEC survey on target-date funds.
The contrasts can be stark, Wulfsberg notes, citing data from research firm Morningstar: The T. Rowe Price Retirement 2030 Fund, for example, has 82% of its assets in stocks and 17% in bonds and cash, while the Fidelity Freedom 2030 Fund is 62% stocks and 38% bonds and cash. Over the past three years, the T. Rowe fund had an annual return of 14.8%, and the Fidelity offering (which launched in 2010) trailed with 11.4%.
Also, these funds have varying takes on the “glide path” to the target. The glide path is the allocation change over time as its stocks component gradually falls and the bond portion rises. Regardless of the particular mix, as you near retirement, your TDF allocation should become more conservative.
One point where they differ is whether the fund glides to or through the target date. “To” glide paths have low equity exposure at age 65 whereas “through” glide paths have much more risk at age 65, and then it decreases as you approach your life expectancy.
The “to” glide path fund works from the philosophy that the participant wants minimum risk at age 65 might roll the 401(k) to an individual retirement account to begin distributions.
The “through” fund company views longevity, not market slides or volatility, as the greatest risk to a 65-year-old retiree and therefore keeps a higher proportion of equity assets.
Which philosophy is correct? Neither. They are merely different. But as an individual investor you have to proactively look for the glide path and specific allocation proportions in a target-date fund or any other investment vehicle.
Before blindly choosing a TDF and assuming that it handles asset allocation the best way for you, speak to a financial advisor or your company’s plan sponsor to make sure that the fund you are eyeing is right for you.