Questioning Target Date Funds

The Securities and Exchange Commission noted similar issues in a summary of proposed rules governing how target date funds are marketed and sold.

"Although the 2009 returns were positive, the differences between 2008 and 2009 returns demonstrate significant volatility," noted the agency. "In addition, 2009 returns, like 2008 returns, reflect significant variability among funds with the same target date."

Another problem isn't so much with target date funds themselves as with the implicit faith placed in them by 401(k) sponsors. The fact is many employers may conduct a certain degree of due diligence among the open funds offered, but they often tend to take the target date funds on faith. This is especially true if the 401(k) plan is via one of the fund company platforms that offer a family of target date funds.

In Wohlner's view, the whole "truth in labeling" thing is a key issue. He's in the process of starting a separate advisory firm to offer direct investment and retirement planning advice to plan participants because he sees a need for an alternative to target date funds.

Liability Questions

"Selecting target-date funds does not relieve fiduciaries from the responsibility of evaluating the quality of target-date funds and their performance," stated Darwin Abrahamson, CEO of Invest n Retire in a white paper titled "Target-Date Funds Risky for Plan Fiduciaries." He argues a 3(38) investment manager is a more prudent choice than target date funds for 401(k) plans.

A 3(38) investment manager is "open-architecture" and differs from target date funds in two important ways — the asset allocation models can be designed to match the specific objectives and demographics of the plan, and sponsors are free to select their preferred investment manager.
However, using a target date fund as the plan default presents significant liability risks that are not present with asset allocation models.

One such risk is that the 401(k) plan has no ability to alter the asset mix or replace an underlying component manager, even if it would be prudent to do so. "While the plan could always replace the entire target date fund structure, such a change is reactive, time-consuming and expensive — and if the plan adopted a different single-manager target-date fund structure, it could find itself facing the same decisions again in the future," stated Abrahamson.

Regrettably, most mutual fund companies employ a closed architecture strategy by offering target date retirement funds using their own proprietary mutual funds. These underlying funds many not necessarily be the best choice for investors, especially if they're actively managed funds with consistent underperformance.

The Future

Another major obstacle for target date funds are high costs. The average annual expense ratio for target date funds is close to 1.25 percent, making them likely to underperform against a lower cost portfolio containing stock and bond index funds over the long run. Target date ETFs, however, have made strides toward greatly reducing investor's costs. BlackRock offers a series of seven iShares target date ETFs with average annual expense ratios of just 0.30 percent. The funds have target dates with five year increments from 2010 (TZD) to 2040 (TZV) and they use iShares ETFs as the underlying investments.

Unfortunately, most 401(k) investors don't have access to low cost ETFs because  their employers don't know any better or because they have a 401(k) plan built upon outdated legacy platforms that only accommodate mutual funds. As a result, the widespread usage of target date retirement ETFs is still limited. 

Conclusion

In the end, target date retirement funds are not a panacea and while they have some benefits, they still have many flaws. Their recent performance during extreme market conditions is mixed; one size does not fit all and excessive fees hurt performance. Regardless, some financial advisors still think the benefits of target date funds outweigh the negatives.

In contrast, other advisors question the ultimate value of target date funds, particularly their ability to execute on their promise. They perceive that target date funds will never be able to build a customized investment portfolio that's tailored to an individual's unique investment goals.