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.