Target Date Funds And Your 401(k) - Part 1

Target Date Funds (TDF’s) have become a popular option in 401(k) and other defined contribution plans as they offer to simplify investor’s decision making. These offerings are typically “funds of funds” meaning that they are managed using other mutual funds, (usually from the fund family sponsoring the TDF) as the underlying fund investment holdings. For example, Vanguard target date funds are managed using other Vanguard funds as the underlying investment vehicles. TDF’s are managed to become more conservative (less stocks, more fixed income) as the holder approaches retirement. This relieves investors from having to make timing decisions regarding their portfolio.


Despite a great deal of regulatory scrutiny during the 2008 financial crisis, TDF’s have been adopted by many 401(k) plans as a default investment for plan participants who are auto enrolled (placed in the plan automatically when they become eligible). A practice endorsed by the U.S. Department of Labor. A recent article in the Huffington Post http://www.huffingtonpost.com/2011/12/30/no-lost-generation-for-ge_n_1176557.html indicated that despite opinion poll data that shows investors are less willing to take on risk by investing in stocks than in the past and that many are distrustful of the financial markets, more Americans than ever have some of their money in stocks. In fact, the number of retirement plan participants in their twenties who had 80 percent or more of their 401(k) funds in stocks grew to an all-time high of just over 60 percent. Since this is the age group most likely to have been auto enrolled, it makes sense that the increase is primarily due to the use of target date funds as the default investment option. The diversified nature of TDF’s would require stock content and the long time horizon of the funds used by younger participants would indicate a high stock allocation.

While I agree with the concept of TDF’s, I have often been critical of the execution. My criticism has centered on three key issues. The first and most critical is that there is no mechanism to match the investment allocation of a TDF to an individual investor’s risk tolerance. In other words, even though you and I may be planning on retiring around roughly the same time, we may not have the same tolerance for risk in our retirement investments. When investing in retirement date portfolios we are forced to accept what someone else dictates as an appropriate asset allocation and risk level for someone retiring within a certain date range. Which brings us to the second issue, opinions differ greatly on the appropriate risk level for any given time horizon. Hence, there is an incredible amount of variation in the amount of equity (stock) exposure between funds with the same target retirement date in portfolios run by different management groups. During our research for clients we have seen TDF’s from different vendors with the same target date differ in equity content by as much as 30%. The third problem is the fact that most individual investors really have very little idea of what they are buying when investing in target date funds or what’s in them. They simply fail to do the appropriate research.

If you are a 401(k) participant and you are using a Target Date Fund for some or all of your retirement investing, make a News Years resolution to find out exactly what you are investing in and if you are comfortable with the risk involved. Start with the information provided by the plan vendor. If you need help, determine if your plan offers the help of an investment advisor. If the plan fails to provide adequate advisory services (a not uncommon occurrence) find a fee-only investment advisor to guide you. Information on qualified fee-only investment professionals near you can be obtained at http://www.paladinregistry.com/. In our next post we’ll share the protocol that we use at Pilot Capital http://www.pilotcapitalmanagement.com/ to evaluate whether the target date funds available in your 401(k) plan offer a superior opportunity.



Note that this post was prepared from material believed to be accurate at the time of posting. Pilot Capital Management, Inc. does not warrant or guarantee that said information was accurate. This blog represents opinion only and should not be construed as investment advice. Investors should always consult their own investment and tax advisors regarding the suitability of any investment for their particular needs.