Thursday, February 11, 2010

Are Target Date Funds good, bad or just plain ugly?

Target date funds have been in the news quite a lot over the past few years, though the nature of the news seems to have gone from great to bad over that time. Consider that when target date funds were first introduced they were heralded as the pinnacle in the evolution of investment vehicles. They were the ultimate in "set it and forget" investing!

These funds were so universally praised by the investment community and politicians alike that when congress passed the Pension Protection Act (PPA) allowing companies to automatically enroll employees in 401(k) accounts, it was target date funds that were chosen most often as the default fund, or "qualified default investment alternative" (QDIA) in the lingo of the PPA.

Then the crash of 2008-2009 happened.

2010 Target date funds performed horribly in that crash. This gave target date funds a lot of bad publicity. After all, the idea of a 2010 target date fund was that it would be invested in less risky assets as 2010 got closer, right?

Maybe.

See, the problem isn't really that these funds lost as much as the average stock fund, or even that they were tilted too heavily in the direction of stocks. There are really two problems at the root of all this:

  1. The crash of 2008 was not a garden variety stock market crash.

  2. People's perspectives on retirement savings is skewed.


Problem One: The crash of 2008.


The crash of 2008 was a once in a lifetime kind of phenomenon, one in which almost every investment asset lost value. The problem for target date funds regarding this kind of crash is: where should the majority of assets held in a 2010 target date fund be allocated?

In a garden variety stock market crash, or correction of say 10-15% or even 20% loss in stocks, a hefty bond allocation is usually enough to provide proper ballast to limit the total losses for the fund. But in 2008, just about the only safe place was cash, or gold and in any normal investment environment a majority of holdings in cash or gold would be a money loser.

Problem Two: Investor perspective.


This problem affected target date funds because investors simply did not expect a 2010 fund to lose 35% -40% of its value so close to the target date. But I think this is really the result of an underlying mistake in expectation on the part of the investor.

Too many investors have it in their mind that they will be taking all their money out of the stock market when they retire.

Maybe it's the way these funds are marketed, but I know a lot of investors think that the clock stops when they retire and that what they have in their investment account is what they have for the rest of their lives. This is simply not true. The average retiree today can expect to live another 15-20 years. The fact is that they will still need to be invested in stocks in order for their savings to last as long as they do.

Solutions.


I think just about the only solution one can have for the first problem (the unusual market crash) is to have a sizeable sum of cash saved up for immediate access if you have just retired or are about to retire when such a crash hits. Something along the 9-12 month of expenses range, maybe more if you tend to panic about finances. This ought to allow the investor to weather the crash and not have to deplete his investment account while it is suffering heavy losses.

The solution to the problem of investor perception is also covered by the huge sum of cash savings fix to the first problem, but there is also a long term mental shift that needs to happen. Investors and retirees need to consider post-retirement investing. Far too many people think about investing or saving for retirement as the end game, when in reality it's just an inflection point where the nature of investing changes but the need continues; the only true end point is the end of life, after which you get into estate planning.

1 comments:

Daddy Paul said...

I have a few beefs with target retirement funds. One the only consideration for asset allocation is a person’s age. Next if you look at these funds they are composed of funds from the same family giving you less diversification than you would think. Lastly many of the funds in these target funds are bloated.
My advice is do your own asset allocation and buy mutual funds to fit your needs. Short of that if you unwilling to do that invest in a couple of good balanced funds.

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