Target-date funds were supposed to be the ultimate idiot-proof investment vehicle for retirement savings.

The idea is that asset allocation is the single most important factor in determining investing success, and most people get it wrong. Many others never even try because they find the concept too daunting.

Many people know they should save for retirement, but they don’t want to be investors – they don’t know whether they should invest in stocks, bonds, or mutual funds. Enter target-date funds.

Target-date funds are supposed to take all that complexity out of saving for retirement. You simply choose the target date of your retirement, and the investment firm does the rest. It’s like auto pilot, with the fund manager gradually shifting more of your assets to bonds as your retirement date gets nearer, thus reducing the volatility and preserving the value…. in theory.

What happens when theory meets reality is a different story.

As a recent article from USNews points out:

“Many target-date fund investors, including those near retirement age, recently suffered large losses. Long-term investors with a retirement date between 2050 and 2055 had a median return of negative 47.5 percent between October 2007 and February 2009, according to a recent Watson Wyatt analysis of 72 target-date funds.”

No big deal, right? I mean 2050 is a long way off, and those investors should expect some volatility in order to earn more overall. Fine. But here’s where it breaks down:

“Those on the verge of retirement didn’t fare that much better. Investors interested in retiring in 2010 had a median return of negative 31.9 percent. But losses varied considerably among funds because of the large differences in stock market exposure. Funds with a target date between 2050 and 2055 were invested between 51 percent to 95 percent in equities, Watson Wyatt found. Those with a retirement date of 2010 had between 32 and 80 percent of the fund exposed to the stock market.”

Two years out from retirement and some funds had as much as 80% in stocks?!

That’s criminal!

Those managers got greedy and wanted to keep their returns high, so they took on much more risk than advertised. That violates the entire intent of target-date funds, and also violates the faith with which investors invested in those funds.

Let this be a stark reminder that there is no true risk-free, cruise control method for investing. You have to know what you’re investing in.

Incidentally, this is also a reminder of why index investing is so popular. People in those funds could have invested 80% of their money in a broad based ETF (like the Vanguard Total Stock Market ETF VTI) and 20% in the iShares Lehman Aggregate Bond AGG ETF and gotten the same results (OK, very similar results) with far less fees and the knowledge that such losses were an inherent risk of the asset allocation, and not subject to the whim of a fund manager!

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3 Responses to “Beware Target-Date Funds!”

1. Daddy Paul says:

   February 12, 2010 at 10:03 am

   I do not like target date funds for a number of reasons. My biggest beef is they consist of a number of funds from the same fund family which really means less diversification than you are lead to believe. “Target retirement funds are a bastion of mediocrity”. My advice is you are unwilling to do the work to come up with a good asset allocation for you buy a good balanced fund.
2. Mike says:

   February 12, 2010 at 5:09 pm

   @Daddy,

   That’s definitely a valid criticism but I haven’t been aware of that being a large part of the “why target funds are bad” sort of articles I’ve read… those seem to be focused mainly around asset allocation and performance.

   Thanks for adding another point to the discussion!
3. What To Watch For In Your 529 College Saving Accounts. says:

   February 24, 2010 at 1:36 pm

   [...] carry the same risk as target-date funds that hi-lighted by the After Hours Investing blog post Beware Target-Date Funds! . Namely, age-based funds carry non-uniform [...]