Considering a Target-Date Fund? Read the Fine Print
The mutual fund industry developed target-date funds as a way to help investors match their investment strategy to their expected retirement date. Investors purchase a fund with a target date aligned with their expected retirement date. As the fund approaches its target date, its asset mix becomes more conservative—reducing exposure to stocks and increasing exposure to bonds. Investors are free to focus on other issues while the target-date fund manages the asset allocation process. The popularity of these funds has increased significantly in recent years; more than $140 billion has flowed into target-date funds since 2007.
One Size Does Not Fit All
Despite generally optimistic expectations for target-date funds, 2008 performance results varied widely, particularly for investors nearing retirement. Morningstar reported that the average loss in 2008 for the 31 2010 target-date funds that it tracks was nearly 25%. Some 2010 funds lost more than 40% in 2008—a loss greater than that of the Russell 3000 Index (a broad index of U.S. stocks).
The equity glide paths (the pace at which funds become more conservative) of target-date funds can vary significantly from fund to fund. In 2008, the proportion of the 2010 funds allocated to stocks ranged from a low of 9.15% to a high of 65%.
Companies that offer target-date funds with high equity allocations explain that they design their funds to provide investors with income beyond retirement. These companies reason that equity investments are needed to generate long-term income, due to the effects of inflation and increasing life spans. The funds with the smallest equity allocations assume investors need to access their entire balance at retirement, and therefore have a greater emphasis on capital preservation.
Investors in 2010 target-date funds with higher equity allocations were caught off-guard when their fund balances decreased significantly in 2008. In fact, the mutual fund industry recently has come under intense congressional scrutiny for the high levels of risk borne by some 2010 target-date fund investors.
Fees and Expenses Can Really Add Up
Before investing in a target-date fund, make sure you know its expense ratio, a fee expressed as a percentage of each dollar invested. Target-date funds generally are composed of a group of other mutual funds. The fund manager selects which mutual funds to use and the amount to invest with each fund. This structure generates two layers of fees. The managers of the underlying mutual funds collect the first layer of fees, and the target-date fund manager collects the second layer of fees, referred to as management fees.
This fee structure is fraught with conflicts of interest. Instead of using the best mutual funds, most target-date fund managers use mutual funds from their own firms. As a result, an inherent tendency exists to build target-date funds with more higher-fee stock funds than lower-fee bond funds, generating more income for the firm. According to Morningstar’s Target-Date Series Research Paper: 2009 Industry Survey, on an asset-weighted basis (i.e., with larger funds counting proportionately more in the calculation than smaller funds), annual expense ratios range from 0.19% to 1.82% among the 48 target-date fund families that it tracks. In fact, more than half of the target-date industry’s fund families have annual expense ratios greater than 1%.
The impact of fees can be quite dramatic. Consider the following example. Investor A and Investor B both invest $10,000, and they both earn an 8% gross annual rate of return. Investor A, with a 0.5% annual expense ratio, will recognize 35% more earnings over a 30-year period than Investor B, who faces a 1.5% annual expense ratio.
A Vanguard study found that target-date funds help to moderate asset allocation extremes, so that investors are not significantly overweight or underweight in any asset class. However, investors still must fully grasp the expenses and strategy of each fund. When choosing target-date funds, you should be skeptical of those that charge a hefty management fee on top of the underlying fund fees. In addition, target-date funds’ fees should decrease as the funds approach their target date, because the funds will be holding more inexpensive bond funds and fewer expensive stock funds. In addition, it is important to find out whether the fund manages to retirement or through retirement—potentially decades after the fund’s target date.
The LifeStage Alternative
The General Board offers the LifeStage Investment Management Service (LifeStage) instead of target date funds. LifeStage is a tool that customizes each participant’s asset mix depending on age, risk tolerance, the current value of expected Social Security benefits, balances in General Board-administered retirement plans and other factors. Based on these variables, LifeStage generates an appropriate mix of investments among five of the General Board’s funds. It gradually changes the investment mix to become more conservative as the participant approaches retirement age. LifeStage, unlike target-date funds, is not designed to be a one-size-fits-all program.
Target-date funds typically do not include a stable value component in their asset mix. However, one of the five General Board funds used by LifeStage is the Stable Value Fund. This provides greater protection for the account balances of participants approaching retirement.
LifeStage administers Ministerial Pension Plan (MPP) balances and non-MPP balances differently. It manages MPP investments to retirement and more quickly reduces riskier equity investments as retirement approaches. On the other hand, LifeStage manages non-MPP investments through retirement by maintaining higher equity positions.
The General Board recently conducted an analysis comparing the 2008 investment results of LifeStage to those of 2010 target-date funds. All data regarding target-date funds were provided by Lipper and Wilshire Compass. On January 1, 2008, the average asset allocation for all 64-year-old participants who use LifeStage for both MPP and non-MPP balances was 32% U.S. Equity Fund, 15% International Equity Fund, 12% Fixed Income Fund, 12% Inflation Protection Fund and 29% Stable Value Fund. Assuming this asset mix remained constant throughout 2008 and there was no rebalancing, this asset mix would have generated an annual return of -17.5%. Actual 2008 returns for participants may have differed due to individual allocations and rebalancing. In contrast, on average, the 2010 target-date Funds declined 25.9% in 2008.
This hypothetical difference in investment performance is likely due to these features of LifeStage:
- an allocation to stable value investments,
- lower expense ratios,
- a more diversified asset mix,
- a lower equity allocation, and
- the General Board’s freedom to hire nearly any investment manager.
The performance gap between LifeStage and target-date funds narrows among funds with target dates beyond 2010 due to higher equity allocations for both the target-date funds and LifeStage.
Make an Informed Investment Decision
Before investing in a target-date fund, make sure you know how much the fees are and whether the fund manages to retirement or through retirement. Target-date funds may be an appropriate investment for some investors, but they are not customized products, as is LifeStage. Take some time to carefully consider whether a target-date fund or LifeStage is appropriate for your needs.