Why Are Target Date Funds Often Misunderstood and Misused?
Target date mutual funds have become more common and more popular in 401(k) plans.
The "target date" of the title is a projected retirement date. Participants choose a fund based on their age or when they want to retire. The fund's allocation mix, usually stock and fixed income funds, is automatically adjusted to become more conservative as the participant nears the selected retirement date. That way, significant market losses shouldn't negatively impact the participant’s ability to retire.
It sounds like a pretty good system, but there are a couple problems.
- Target date funds do not have standard asset allocation guidelines.
- Participants rarely understand the funds' true risk exposure.
Most mutual fund companies currently offer their own suite of target date funds, usually constructed of funds proprietary to the underwriting fund company. The funds' asset allocations are set independently by each individual fund company, without any coordination with their peer group.
Some funds use the "to retirement" method to calculate allocation percentages. Others use "through retirement." This disjointed process produces different asset allocation for the same target retirement date.
Take, for example, the Target Retirement Date 2015 Fund. The "to retirement" fund would allocate very conservatively, on average holding 25 percent of assets in stocks and the rest in fixed income instruments. The "through retirement" method, however, would result in an allocation of up to 70 percent in stocks.
Plan participants who don't understand the differences in the two methods could get an allocation mix that is not right for their needs.
As for risk levels, our analysis found significant misallocations in nearly three-quarters of plan participants who invest in target date funds. Most of them are exposed to more risk than they indicate they are willing to take.
When an investor takes on more risk than he or she can tolerate, a poor investment decision is imminent, resulting in performance substantially lower than market averages.
If your plan offers target date funds, education of your participants about the funds is critical. Information on asset allocation of the funds will enable participants to determine what risk profile is appropriate for their specific situations.