They are supposed to be the “set-it-and-forget-it” vehicle for retirement investors who don’t know how to — or just don’t want to — micromanage their money.
Many investors have a general understanding of how the funds work and that they typically reduce a portfolio’s equity exposure and increasing allocation to bonds and cash as a person gets older. But as anyone who had plans to retire in 2008 can attest, assessing the risks of using the funds can be a little trickier.
“Those people thought they were being defaulted into something safe. Then they lost a third or a fourth of their assets in one year,” says Ron Surz, chief executive of Target Date Solutions, which designs target date funds. “That’s not safe.”
During that crash, the main risk was the stock market. Today with stocks at new highs and bond yields hovering near record lows, investors have more than stock losses to worry about: What they’ve long viewed to be the safer part of their portfolio, the bonds, may soon start to show more volatility than they have in the past three decades.
As employers, fund providers and others look for ways to simplify the process of saving for retirement, target-date funds are often part of the solution. But if you’re not using the funds as intended, they could add unnecessary risk to your portfolio.
Some other things to be aware of:
You might own one and not even know it.
Target-date funds are designed for people who don’t have the time or energy to manage their retirement savings. Since the Pension Protection Act of 2006, which allowed companies to automatically enroll employees in a workplace savings plan, the big driver of money into target date funds is from employers enrolling workers into them.
That means workers who haven’t put much thought into what’s going on in their 401(k)s probably own one. Target-date funds are the No. 1 choice for employers defaulting their workers into retirement accounts: 85 percent used them last year, up from 78 percent in 2011 and 50 percent in 2007, according to Aon Hewitt, a human resources consulting firm. “You need to know what you’re being defaulted into,” Surz says. “I don’t think most people do.”
It’s easy to see why the funds are a popular option for employers who want to make retirement saving easy. Target-date funds are set up to automatically reduce an investor’s risk as he approaches retirement. When left to their own devices, many investors may not put in the work needed to rebalance and adjust their allocations over time.
But allocation decisions should be based on more than just time, they should also factor in goals and an appetite for risk, says Scott Holsopple, a managing director at the Mutual Fund Store, investment advisers focused on retirement planning. As a result, some target-date fund investors may find themselves investing too aggressively — or not aggressively enough. “A one-size-fits-all solution sounds good,” he says, “but sometimes it’s too good to be true.”
If you’re going to use them, it should be all or nothing.
The rule has been deeply ingrained in investors: Putting all of their money into one fund is a bad idea. But that goes out the window with target-date funds, which invest in a mix of asset classes — such as stocks, bonds and alternative assets — typically by using several mutual funds. That means people who put some of their money in target-date funds and some of it elsewhere may be getting too much exposure, or not enough, to certain asset classes, says Rob Austin, director of retirement research at Aon Hewitt.
Also people may not be using the funds as intended: Last year, 65.8 percent of 401(k) participants used pre-mixed portfolios such as target-date funds, but of those savers, only half had all of their money invested in the funds, according to Aon Hewitt. Among partial target-date fund users analyzed by Aon Hewitt and Financial Engines, an investment adviser, about a third of investors had too much risk, when comparing their actual stock allocations to that in their target-date funds, and another third had too little risk.
“People have heard for years, don’t put your eggs in one basket,” Holsopple says. “So they put a little bit of the money in a target-date fund and a little bit somewhere else and that is not how you are supposed to use them.”
Older savers are more likely to hold other funds in addition a target-date fund, says Mathew Jensen, director of target date strategies at Fidelity Investments. That could be because younger investors are defaulted into a target-date fund after starting a job or it could be that savers decided to take a more active role after amassing more in savings, he says.
That mistake is particularly worrisome when people invest outside their target-date funds because they want to buy into stocks or assets that did well the previous year and may be overpriced, Austin says. Another mistake is to use outside money to buy company stock, which may seem appealing but could up the risk in a retirement portfolio by making its performance more vulnerable to the fate of a single company. It can also leave investors holding more stocks than they intended, if they don’t take into account the portion of target-date fund that is invested in equities.
Austin says investors should become familiar with the current allocation for their target-date fund, and how that is expected to change over time, before making other investments with retirement savings. Holsopple says people who want to take a more active role in managing their retirement savings may be better off creating their own portfolio out of mutual funds and exchange-traded funds if they make a point to rebalance regularly.
Even the safe part of the portfolio has risk.
Target-date funds are designed to ratchet down risk as investors approach retirement, largely by reducing the allocation to stocks and upping the portion of the portfolio invested in bonds. But some investors are worried that even the safe part of the portfolio could be due for a shakeup.
After decades of declining bond yields, some say that bond yields are so low today that they have nowhere to go but up. The Federal Reserve, which has set short-term rates near zero, could increase those rates as early as next year. And because of how bond pricing works — bond prices decline when bond yields increase, and vice versa — that means bond investors could see losses when the market shifts.
Some fund managers are mitigating that risk by using short-term bonds, which should not drop in price as much as long-term bonds would if interest rates increase. Jensen of Fidelity says the firm uses a diverse bond portfolio that holds floating rate notes, which invest in adjustable rate notes, emerging market debt and high-yield bonds. Robert Reynolds, the chief executive of Putnam Investments, says that Putnam’s use of absolute return strategies, funds that aim to bring in a targeted level of returns at low volatility, helps reduce volatility in its target date funds.
Of course, even if bond values drop, price changes probably won’t be as dramatic as the losses investors could see in the stock market. And managers say the diverse nature of the funds alone can help them offset any losses the funds incur with bonds. For example, the Barclays U.S. Aggregate Bond Index fell 2 percent last year, but the Standard & Poor’s 500 stock index gained more than 30 percent, helping the target-date funds coming due between 2016 and 2020 to notch in an overall gain of about 12 percent, according to Morningstar.
Two people retiring on the same day can have very different portfolios.
Most target-date funds work the same in that they invest in a variety of asset classes and reduce risk as a person approaches retirement. But fund providers are divided over whether the funds are intended to bring savers to retirement or through it. That means two target-date fund investors planning to retire in the same year could find themselves with wildly different portfolios.
Generally speaking, fund providers that work on bringing people “to” retirement will notch down the risk more quickly than “through” funds that aim to have the savings grow even once the person is retired. But the takeaway for retirement savers is to be sure to use a fund that will leave you with a risk level you can stomach on the day you stop working.
Fidelity Investments, which is in the “through” camp, brings the allocation to domestic and international stocks down to about 60 percent of the portfolio at the retirement date. Vanguard Group is also in the “through” camp, but its target-date funds are only 50 percent invested in stocks in the year when an investor is expected to turn 65. And Blackrock, which is in the “to” group, has a target equity allocation of 40 percent at the retirement date.
Whether those allocations are too risky — or not risky enough — is a question for which the answer will change investor by investor. That’s why it’s important for people to know where their target-date fund will be on the day they retire, says Michael Kitces, director of research for Pinnacle Advisory Group. “If you are unhealthy and only planning to enjoy a 15-year retirement, you probably don’t need something that’s got 65 percent in stocks,” Kitces says. “If you have parents who are in their 90s, you probably don’t want something that is 20 percent in stocks.”
Catherine Gordon, a principal in Vanguard’s Investment Strategy Group, says the firm’s target-date funds work to get people through the early years of retirement, when some may decide to keep working full time or to take on part-time work. “People aren’t drawing down their retirement accounts from day one where they walk off the job,” Gordon says, adding that many people wait until they’re age 70 ½ and are required to take distributions by law. But someone planning to draw down savings on day one might be more comfortable with a more conservative fund.
And they probably got there in vastly different ways.
All target-date funds work to reduce equity allocations for investors as they get older, but just how they decide to change that exposure can vary greatly depending on the fund. Some funds will reduce stock holdings by certain amounts at specific intervals, while others are more gradual about the change. Another way to think about it: Some will start decreasing stock exposure long before retirement, while others wait until a person is closer to it.
Investors may be more comfortable with more risk if it means they might see greater returns, Kitces says, while others would prefer a safer approach.
After learning more about how the funds work, investors who are unhappy with the risk levels in their target-date funds may be able to switch to another fund — but some plans may limit them to funds from the same family. In that case, Kitces says, those who want to take more risk may need to switch to a target-date fund with a later retirement date and those who want to be more conservative may want to switch to a fund with an earlier one.