5 Major Flaws of Target Date Retirement Funds

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Target-Date Funds are being sold as the panacea to everything that ails retirement savers. And 401(k) retirement plans are buying in.

Nearly 25 percent of 401(k) participants invest solely in target-date funds (TDFs), according to new study from the Vanguard Group. A major factor influencing the rise of TDFs is the automatic enrollment of participants into their 401(k) plan and the plan sponsors' decision to choose target-date funds as the default investment option.

Forgetting History

During the 2008-09 financial crisis, many target-date funds blew up with the rest of the market. But since the public suffers from amnesia, nobody remembers. And the mutual fund industry isn't about to help them remember.

 

Target-Date Funds attempt to match a person's age and risk tolerance with a projected retirement date. For example, the Vanguard Target Retirement 2050 Fund (Nasdaq: VFIFX - News) is aimed at people in their mid-20s, whereas the Vanguard Target Retirement 2035 Fund (Nasdaq: VTTHX - News) is designed for individuals in their 40s and the 2015 Fund (Nasdaq: VTXVX - News) is for people in their early 60s.

The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. Funds gradually shift their investment mix from more aggressive investments to more conservative as they approach their designated target date.

Major Flaws with TDFs

Despite their noble attempt at helping people to save and invest for retirement, TDFs have many serious flaws that are being ignored or purposely hidden. Here's just a few of these flaws: 

1) TDFs encourage the public to be lazy when it comes to asset allocation. A person's first choice for their retirement investments should always be a customized mix that perfectly matches their age, risk tolerance, and goals rather than a canned one-size fits all retirement fund that happens to be a default choice.

2) TDFs undermine the vital role of professional investment advice. If the main purpose of a TDF is to help 401(k) savers to get the right asset mix, of what value are financial advisors who provide the same service? When I worked as a financial advisor, I never recommended TDFs because I recognized the threat they posed to the personalized investment advice I was giving to my clients. And now, as an outside observer, my views haven't changed. I think any financial advisor who recommends or sells a TDF is out of their mind.

3) TDF fees are still too high. The average annual cost for TDFs is 0.62 percent, which is ridiculously inflated for the amount of actual work these types of mutual funds do. Talk about a wonderful profit center for mutual fund companies! 

4) TDFs don't properly tackle the issue of longevity - a serious problem that faces millions of retirees. A TDF that switches the bulk of its allocation to bonds (NYSEArca: AGG - News) when a person reaches the standard retirement age range of 65-70, may subject these individuals to huge inflationary risks should they end up living another 20 to 30 years.

5) TDFs are not adequately diversified. No matter what fund companies say, most TDFs are grossly underdiversified because they miss market exposure to major asset classes like commodities (NYSEArca: GCC - News), global real estate (NYSEArca: RWO - News), international bonds (NYSEArca: BWX - News), and TIPS (NYSEArca: GTIP - News). Various academic studies show that exposure to stocks (NYSEArca: VTI - News), bonds and cash alone is not true diversification - and anyone that says it is, has a distorted perspective. 

Conclusion

It's true that a TDF default choice is better than nothing, but it's not better than a customized investment mix that perfectly matches a 401(k) participant's unique investment needs. Furthermore, the fees being charged by most TDFs are excessive, which will greatly reduces the retirement income benefits of the people buying them.

Despite the so-called improvements to glide paths and other financial engineering to make them better, many TDFs have simply increased their market exposure to bonds, as a knee-jerk reaction to the stock market clobbering they took in previous years. No doubt, these very TDFs will take a beating when bond prices start faltering. In other words, TDFs are basically the same products as they were a few years ago, but with prettier packaging.

Ron DeLegge is the Editor of ETFguide.com and author of 'Gents with no Cents: A Closer Look at Wall Street, its Customers, Financial Regulators and the Media.' (Half Full Publishing, 2011.)

 



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