If you participate in a 401(k) plan, chances are you've heard of target-date funds.  Perhaps you've even been told that your contributions will default to such a fund if you don't specify otherwise.  In the last few weeks I've worked with employees of at least 4 employers for which this is the case.  All in all, more than 70% of 401(k) plans now offer target-date funds, and for various reasons they are often the default option for new participants in the plans.  Another popular use of these funds is in 529 plans for college savings.

So...what is a target-date fund?

A target-date fund is a mutual fund that invests in multiple asset classes in a way that is designed to be appropriate for a time horizon defined by the fund.  The asset mix changes to become more conservative over time, as the target date gets closer.  This change in asset mix over time is commonly referred to as the glide path.  Because it invests in multiple asset classes, such as various classes of stocks and bonds, and alters the asset allocation over time, the target-date fund is really designed to be a portfolio unto itself.  In practice, such funds will typically invest in several other mutual funds, each of which is dedicated to a specific asset class.

Challenges of target-date funds

Probably the most significant over-riding challenge associated with target-date funds is the fact that many consumers group all such funds together.  I think most tend to understand the difference between a fund targeted at, for instance, retirement in 2015 vs. retirement in 2040, fewer seem to distinguish between the 2040 offering from Vanguard and the 2040 offering from T. Rowe Price or Fidelity.  These funds are not necessarily managed in a similar manner.  Asset allocations will likely differ, and the underlying funds that the target-date funds own will certainly be different.  A recent Government Accountability Office (GAO) report found that the performance of these funds varies widely from family to family.

More specific criticisms include:

Expenses - Target-date funds typically charge fees at the fund level, including a management fee to cover the effort associated with defining the asset mix and selecting underlying funds in which to invest.  Of course, these underlying funds charge fees of their own, which results in the layering of fees.  The underlying funds are often index funds, and the associated fees can be relatively inexpensive.  That's not always the case, though, and it takes some digging to unearth the total cost of investing in target-date funds.

One-size-fits-all approach - The fact that two individuals plan to retire in the same year does not mean that an identical investment approach is warranted.  Among other things, they may be different ages, and may have different levels of risk tolerance.

Investments - The fund family that manages a target-date fund will typically look to invest in funds from within the same family.  For instance, Fidelity will invest in Fidelity-managed funds, the MFS Lifetime funds invest in other MFS-managed funds, etc.  Without trying to indict a specific fund family, there may be an incentive to use less popular and less successful funds within the target-date funds.

Are they good for anything?

I think the best argument in favor of target-date funds is that the better ones serve as a reasonable default option for investors who will not otherwise put forth the effort to select funds in a methodical manner, according to an allocation that makes sense for them.  If they prompt people to save who otherwise wouldn't, regardless of the reasons, they are probably serving a valuable purpose.  Regardless, this is an increasingly broad category of products, and to really ensure that a target-date fund is a reasonable option requires some digging.  

Reminder for Intel employees: this week marks the deadline to elect changes to your investments and contributions related to Intel's overhaul of your 401k plan.

If you're a participant in the Intel 401k plan and don't make an election by Friday, September 9, your existing funds and future contributions will default to a target-date fund that corresponds to your date of birth. This shift will actually take place effective September 30.

The target-date approach may be a good option for you; regardless, it makes sense to review all of the options, ensure you've got complete information regarding expenses, and make a deliberate decision. Consider it an opportunity to put structured decision-making skills to work.

This is a big change. Some of the potential options will cost a lot more than they used to, and that will impact your returns. There have been so many options within the Intel 401k that the impact will be different for everybody. Several of the employees with whom I've spoken have been vaguely aware of a change, but haven't had an appreciation of its significance. If you're not sure what to do, feel free to drop me a line.

Fidelity Investments  recently released a report on 401k participant behavior that details the impact on 401k plans of various courses of action in reaction to the sharp market decline in 2008/2009.  They assessed data within Fidelity-administered 401k plans for the period covering 2008/2009 through Q2 of this year.  They learned that:

• Investors who pulled out of the market completely between October 1, 2008 and March 31, 2009, and stayed out through June, 2011, saw their 401k accounts grow by just 2%. That's for the entire 2-3 year period.
• Those who pulled out but then got back in at some point prior to June 30, 2011 saw their accounts grow by an average of 15%.
• Investors who maintained an asset allocation that included stocks throughout this period saw their accounts increase by 50% over the same period.
• Participants who stopped contributing during the crash averaged an increase of 26% through June, while those who kept making regular contributions saw their accounts grow by 64% on average.

It's important to note that increases included new contributions (in most cases) as well as investment returns.  Nonetheless, it's safe to say that investment returns played a big role for investors who stayed the course.

What does it mean for the future?  It's hard to say.  The future may be different than the past, including all of the other downturns that have occurred in the past century and earlier.  In all of those cases, though, almost all of the investors who had the fortitude to stay the course and kept investing through the downturn would have achieved solid long-term results, assuming the performance of their investments resembled that of the overall markets.  It is worth noting that the S&P 500 has had exactly zero instances of negative returns over a 20-year period.  That doesn't mean that every 20-year period has made millionaires out of all investors, and inflation hasn't been kind to returns in all such periods.  But the stock market has clearly produced better returns than the alternatives over long periods, and investing through a down cycles can create superior results because of the favorability of the purchase price when the market is relatively low.

Fidelity's takeaway from the study?  In the words of James M. MacDonald, their president of Workplace Investing:  "Our analysis reinforces that during extreme market swings, it’s essential for investors not to overreact and remember that investing for retirement requires a long-term view, regardless of their investment horizons."

1. We're living longer.  Of course, this would be less of an issue if we're also working longer, and I suspect that will be a new development as we progress, but right now the study shows the average retirement age at 64 for men, and 63 for women. 

2. Replacement rates are falling.  In this case, replacement rate refers to the percentage of income that is replaced by retirement benefits.  As we move forward, the amount of Social Security that we'll receive is decreasing.  Furthermore, although the article points out that the share of the workforce that is covered by an employer plan has remained steady, the nature and amount of that coverage has changed.  Defined benefit plans, in which a retiree received a fixed percentage of salary, are increasingly rare.  Defined-contribution plans, such as a 401(k), in which employees contribute to prepare for retirements, are now the norm.  This puts more burden on individual employees to save an appropriate amount and to invest it prudently.  That may not be an outrageous expectation, but it's not happening.  As the article points out, the median balance for heads of households entering retirement is only $78,000.  That is not going to go very far, especially as Social Security coverage decreases.

3. Retiree-paid health costs are rising.  This subject is a bit harder to predict, as we await the longevity and full implementation of Obamacare.  However, it's hard to imagine the government picking up more of the tab for the same level of care, given the current underfunding for entitlement programs.  It's possible that we'll somehow see a reduction in the inflation rate of health care costs, but that has not been the trend and it's probably not a solid assumption to make when planning for retirement.

4. Returns have declined.  This is perhaps the shakiest point in the article.  It is true as stated:  asset returns generally have declined over the past two decades, and bond yields are certainly well below average.  However, to a certain degree recent declines have helped to ensure that future growth will be stronger.  I think a more valid point is that we've seen the effect that reverting to average long-term returns can have, and it pays to be conservative when making assumptions about future asset growth for the sake of retirement planning.