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Understanding Target-Date Funds

You’ve probably seen them littering your 401k investment options. You’ve noticed most of the investment options all have dates behind them. By now, you may even understand that these options are target-date funds, also known as lifestyle funds. You may also understand that you are supposed to line up the date with your approximate retirement date.

Unfortunately, that’s where most peoples’ understanding usually ends.

More than $40 billion per year has gone into target-date funds since 2008.

A Brief History of Target-Date Funds

In the past, the biggest issue for companies was that employees would contribute to their 401k, but they wouldn’t pick any options. Their money would sit in these plans completely uninvested. We know that the more options employers give in their 401ks, the fewer people will invest. People see a wide range of options and get hit with paralysis by analysis.

In 2000, Sheena Iyengar and Mark Lepper published a study related to the sales of jam. They went into a food market, and set up a jam table with samples. One table had 6 samples, and one table had 24 samples. The table with 24 samples brought in a lot more people who had more interest in the types of jams offered. However, the study found that even though interest was higher at the table with 24 jams, sales were much lower. The overwhelming choice offered to consumers caused them to be overwhelmed and, as a result, customers did not purchase anything.

We have found this same conclusion when analyzing 401k plans. Overwhelming options cause people to not make any choice at all. Couple that with the fact that picking investments can be difficult, and you have even fewer people selecting options in their retirement plans. How easy is it for a person to sit down, understand when they are going to retire, how much money they will need, the best investment to get them there, how to set a proper allocation, and how to keep that allocation properly balanced? Considering there is a whole profession of financial planners tasked with this analysis, it can’t be easy.

Target-date funds were created to right that wrong. Target-date funds were the magic pill that would properly invest your assets into an allocation of stocks and bonds and then adjust that allocation based on how much time you had left until retirement. If you had 30 years until retirement, your portfolio would be mostly stocks, but if you had a couple of years until retirement, you would expect your portfolio to be mostly bonds or even cash. Not only would they do all of this, but they would do it at reduced fees.

Still, target-date funds’ popularity did not take off. People still didn’t understand enough to make an educated investment selection, but now with more choices, less action was taken.

In 2006, the Pension Protection Act was passed. This gave protection to employers to auto-enroll individuals into investment options. Before this act, employers didn’t want the liability of auto-enrolling an individual into an investment option. What would happen if you were enrolled in an index fund, only to have the market tank a couple of years before your retirement? Heads would roll and employers wanted no part of it.

Luckily, target-date funds helped to solve this issue. After all, if you were close to retirement, the funds were supposed to be mostly in bonds or cash, and the risk to your retirement would be reduced.

Target-date funds may have been a good solution to get people to invest their 401k, but they are far from perfect. There is still a general lack of knowledge about these funds, and this was quickly exposed in 2008.

The Confusion of Target-Date Funds

A recent study by AllianceBernstein quickly exposed that investors do not know a lot about target-date funds, and what they thought they knew about them was alarming.

A majority of investors (72%) knew that target-date funds become more conservative as you get closer to retirement. The other 28% thought this was false, or they didn’t know, but this information is correct. Target-date funds will start equity heavy and then move to more bonds as you get closer to retirement.

Not a bad start for the survey participants, but it gets worse from here.

Only 44% of participants said it was false that your account balance is guaranteed to never go down. 38% thought that was true, and 18% didn’t know. That statement is false. There is no protection in a target-date fund that protects it from losing money. Even bonds can lose money.

Of the participants in the study, only 37% said it was false that target-date funds guarantee that you will meet your income needs in retirement. 48% thought that statement was true, and 15% didn’t know. That statement is false, there are no guarantees in this world. First, target-date funds have no way of knowing how much you will need at retirement. A person who invests 1% of their salary, versus 15% of their salary, will have very different account balances at retirement.

One additional thing to note about the two statements above is any time an investment uses the word “guarantee”, know that the statement is false. There are no guarantees in this world and especially not in investing.

The next survey question stated that at retirement, target-date funds were 100% invested in cash. Only 35% of the respondents knew that statement was false. Unfortunately, this was the portfolio killer for retirees in 2008.

The last question asked if survey respondents thought that target-date funds were insured by the federal government, like bank accounts. Only 33% of participants knew that statement was false. Investments are never covered by FDIC or SPIC insurance.

Understanding Glide Path

We now know that a target-date fund will go from an equity heavy portfolio to a bond heavy portfolio over the course of its life. What we don’t know is when and how that happens.

There is a giant misconception about target-date funds. The misconception is that target-date funds will reach their max bond portfolio around the date listed on the fund. Unfortunately, many people in 2008 found that this was not true.

There are two types of target-date funds: “to-funds” and “through-funds”.

A “to-fund” means that the fund will reach its target allocation by the date listed. This is what you would expect out of these funds. If you were to pick the year you retired as the fund you invested in, you would expect it to be heavy in bonds and safer at your retirement.

A “through-fund” means the fund is going to blow right past the date listed before it reaches its target allocation. In fact, it won’t even really adjust its positions until a couple of years before the target date, and the adjustments could last 20-30 years. This can be a major concern if you are heavy in equities, trying to retire, and the market crashes. This is what people in 2008 realized they were invested in. They thought they had a relatively safe portfolio that should have been heavy in bonds. They were wrong.

What makes this matter worse is that these funds don’t list what type of fund they are. The government realized this error 10 years ago, but has yet to make any sweeping changes to right this wrong. It seems listing a simple “to” or “through” before the date would have made the most sense.

I digress.

As an investor, the best way to know how and when your fund is going to make its allocation changes is through its glide path. A glide path shows the progression from an equity heavy portfolio to a bond heavy portfolio. It will tell you the years it plans to make the switch, how aggressive or conservative it will be, and what the target date really is.

The best way to find a fund’s glide path is to use MorningStar. Enter the fund symbol at the top, click the portfolio tab once the symbol comes up, and then scroll to the bottom to see the fund’s glide path.

Here are two examples of different funds’ glide paths. Both funds have a target date of 2055. The first fund is a “to-fund”. As you can see the target-date is set at 0, and it is at this point that the fund has made the switch to its final allocation. It doesn’t have to be 100% bonds or hold any cash, but it is at the set allocation at which it wants to end.

If you compare that fund to a “through-fund”, you can see how the allocation differs over the same time horizon. The “through-fund” will begin to move more conservatively over the years, but it will not reach its final allocation until 30 years after the retirement date. The first fund reaches its 30/70 equity to bond allocation on the date of retirement. This fund reaches that same allocation 10 years after retirement.

As you can see, not all target-date funds are created equal.

This “through-fund” would be a lot more aggressive at retirement, but a lot more conservative in the later years of retirement. This is only a bad thing if you are not expecting it. You don’t want to invest in a portfolio you think is conservative because you are nearing retirement only to find out it was more aggressive than you planned.

Conclusion

Target-date funds have been a great benefit to retirement portfolios. At the very minimum, they forced people to invest their retirement accounts into something besides cash by defaulting their investments into one of these funds. Besides being the default selection, these funds allow investors to put their retirement accounts on auto-pilot. Most investors don’t understand the different investment options afforded to them, let alone the proper allocation and when to balance the portfolio. In one swoop, target-date funds corrected most of what is wrong with people investing in their retirement accounts.

Unfortunately, regulation stopped short of trying to help correct the misunderstandings these funds produce. A simple “to” or “through” in the name would have made it easier to understand exactly what you are investing in. Granted, this would have only been the start. A simple name change doesn’t increase the understanding of the different types of funds and exactly what they mean or accomplish.

When you are 20 or more years from retirement, the type of target-date fund you invest in won’t have a big impact. It isn’t until you are nearing retirement that an understanding of the different types of funds and their meaning really comes into play.

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