I kind of hate target date funds.

They're supposed to make investing for retirement simple for people who don't want to choose among the options in their 401(k) plans. And, yes, picking a single fund that is (supposedly) optimized to your retirement date is easy. Sadly, it's too easy -- and people who want things easy will likely miss the many pitfalls of these funds.

Think this isn't your problem? You may unwittingly be invested in a target date fund. Many employers have been automatically enrolling workers in their 401(k) plans and putting them in a target fund, as the result of a 2006 federal law.

That's the main reason they're growing so fast. Target date funds hold $400 billion in assets now, and will grow to $2 trillion within a decade, according to a newly released report from Brightscope, a company that ranks 401(k) plans, and Target Date Analytics, which tracks target date funds.

That's a tsunami of money: To put it in perspective, it took the entire mutual fund industry 52 years to grow to $2 trillion in assets.

Before I explain why these funds are troubling, here's a look at how they work: Let's use "Edward" as our fictional worker. He is 36 and wants to retire at 65, in 2040, so he chooses a target fund labeled "2040." Let's call it the "Superstar 2040 Fund."

The Superstar 2040 manager invests Edward's money in a mix of stock and bond funds, reducing the exposure to stocks (and risk) as Edward nears retirement. (The shifting of that mix is known as a "glide path.") All Edward has to do is keep contributing to his 401(k) and let the manager take care of the rest.

Think twice, Edward! Here's why:

1. Some Funds Take Too Much Risk Too Late in the Game.

Imagine you were planning to retire in 2010, and had invested in a target date fund. On average, target date funds set to mature that year declined 37% between the market peak in October 2007 and March 2009, according to Morningstar. Ouch.

Why? Too much exposure to stocks. You would think that after a meltdown like that, fund managers would cut back on holding equities so close to maturity. Not so: The percentage of stocks that target date funds hold at their target date rose to an average of 43% in 2010 from 40% in 2007, according to the Brightscope report.

"Many fund companies failed to learn from the 2008 debacle, which failure will surely hurt participants again," the report concludes.

2. Risks Aren't Clearly Disclosed.

Why would target date funds expose older investors to that kind of risk? There's a debate over whether a target date fund should hit its most conservative allocation -- known as the "landing date" -- the year an investor retires, or provide for the rest of his life.

One camp -- known as "to" funds -- thinks a target date fund should hit the target date and landing date the same year. Thus, our friend Edward retires in 2040 at age 65, just as the Superstar 2040 Fund cuts the percentage of stock it owns to its lowest level. About 40% of funds followed this philosophy in 2010, Brightscope found.

The other 60%, known as "through" funds, think they should provide for Edward for the rest of his life. Since people run the risk of outliving their money, this camp continues to take some risk after the target date so his money has a chance to grow. Thus the Superstar 2040 Fund wouldn't minimize Edward's exposure to stocks until 2050 or later, when he's 75 or older.

In short, it's critical to understand if you have a "to" or "through" fund to gauge your risk, especially if you had planned to take your money out in a lump sum on the target date. However, it's tough to figure out a fund's philosophy by looking at the fund documents. Even the gurus at the Morningstar, which ranks mutual funds, have complained that the data is hard to find.

3. Fund Managers Have Conflicts of Interest, and Mediocre Regulatory Safeguards.

So why would target funds hold so much money in stocks as workers approach their retirement date, when they'll need the money? Answer: More profit for the companies that manage the target date fund. Investors have to pay more for actively-managed stock funds than bond funds (or index funds, which simply mimic the major indexes such as the S&P 500). That gives the managers an incentive to stuff the target date fund with the more profitable (and riskier) funds.

Unfortunately, target date funds are subject to regulation under a 1940 law, the Investment Company Act, that doesn't have to teeth to stop a fund manager from putting his interests above yours. I'd rather see target funds governed by the stricter fiduciary standard, because its transaction and conflict rules are better at protecting investors.

This is a no-brainer: Shouldn't one of the fastest-growing investments for people who aren't paying attention to their retirement money be subject to the highest levels of accountability?

4. Target Date Funds Cost Too Much.

As noted above, target date funds cost too much. On the bright side, Vanguard recently launched target funds with very low operating costs. They have an expense ratio (or operating cost) of 0.18% as a percentage of the fund's net assets. Fidelity and TIAA-CREF followed suit with target funds that costs 0.19%. That compares to an average of 0.75% across all target date funds, Brightscope found.

What does this mean for Edward? Let's say he joined his company at age 35 and contributes $10,000 a year to a target date fund in his 401(k) for the next 30 years. The money grows at an average of 7% annually. When Edward taps the money at age 65, he'll have about $977,000 in the lower-cost target fund –$99,000 more than he would have the higher-cost one.

I'm sure we can all think of something more fun to do with nearly a hundred grand than forking it over to a fund manager. Vanguard has proven that target funds can be managed cheaply with solid performance. (It ranked fifth out of 34 companies in the Brightscope report.) So why can't competitors follow suit?

5. The Largest Players Crowd Out Better-Performing Competitors.

Finally, there's the stranglehold that the big, full-service 401(k) managers have on the target date market. This can prevent investors from getting access to the best-performing funds. For example, if Vanguard manages your 401(k) plan, you're likely to be offered a Vanguard target date fund as an option.

Vanguard likely won't offer access to American Century LIVESTRONG, which Brightscope ranked No. 1 -- four spots above Vanguard. In short, it's so profitable for the largest firms to keep a lock on the target date fund market they aren't going to make an effort to welcome other fund families in the door. In the retail world, that wouldn't fly: Imagine Walmart only offering Walmart brand toilet paper.

Vanguard's response: "For our full-service program... Vanguard offers a flexible investment program that includes both Vanguard and non-Vanguard investment products. Investment committees [at the companies selecting Vanguard] aligned with our perspectives on the importance of low cost, diversification, and the advantages of indexing in retirement portfolios typically consider Vanguard's index and target-date or balanced fund offerings best-in-class. We would look for such plans to offer Vanguard proprietary funds in those categories and as the default option for the plan."

What To Do

My advice? Don't play the set-it-and-forget-it game. Spend an hour a week at a website such as 401khelpcenter.com and learn how retirement investing works. Alternately, spend a few hundred dollars to visit with a fee-only financial planner who charges by the hour. Ask him or her to review the funds in your 401(k) to see if you would do much better by investing in the plan's other options.

But if this step (or its cost) makes you procrastinate, go ahead and invest in the target date fund. Just be sure to pop the ticker of your fund into the "quote" search box at Morningstar.com and look at the ranking and analysts comments to ensure you're not investing in a total clunker.

Then visit that planner when your investment hits $10,000 -- and you have enough skin in the game to care about your money.

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24 Comments

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welcome

Who is Laura Rowley? Is she a financial analyst or just a writer who read brightscope?

October 23 2011 at 6:48 PM Report abuse rate up rate down Reply
mccglf

Pure marketing, nothing more.

October 23 2011 at 10:20 AM Report abuse rate up rate down Reply
brian1russ

Just listen to the "Song and Dance". None of this matters if your employer controls or limits what accounts your money goes into. Myself and many other have invested the maximum in 401k's for 30 to 35 years and see our investment is less than what we put in. I am thakful that I didn't need to rely on it for my retirement or I would have been broke after ten years or less. Now I am saving the 401k for my kids because they probably won't have anything when they retire.

October 22 2011 at 8:13 AM Report abuse rate up rate down Reply
hamila

is it legal for an employer to use your 401k money for his use... he promises to pay it back ...with the correct interest.... is it really possible for him to figure out the correct amt lost???

October 22 2011 at 7:14 AM Report abuse rate up rate down Reply
mizdixie9

And then there is the SEIU that wants all the 401K's dumped in one pot & they will dole out the distributions.
Wonder what the percentage is for handling the funds.........

October 22 2011 at 1:09 AM Report abuse rate up rate down Reply
Joe and Kay

The conclusions of the report are stupid. The reasons that the equiities amount increased from 2007 to 2010 was that the stock market RECOVERED. The risk in the individual components of the assets allocated amoung stocks, bonds, and cash is the market risk undertaken by everyone else. Annual returns will be very close to the overall market return for the asset class. I have nothing to say about their cost except that the costs should be low because most of the investments are in index funds. I am a CFP and a CPA so I have some idea of what I am talking about.

October 21 2011 at 9:36 PM Report abuse rate up rate down Reply
hollytoky

Bill Cosby has a good point. Read on.
Bill Cosby : "I'm 76 and Tired"
I'm 76. Except for brief period in the 50's when I was doing my National Service, I've worked hard since I was 17. Except for some some serious health challenges, I put in 50-hour weeks, and didn't call in sick in nearly 40 years. I made a reasonable salary, but I didn't inherit my job or my income, and I worked to get where I am. Given the economy, it looks as though retirement was a bad idea, and I'm tired. Very tired.

I'm tired of being told that I have to "spread the wealth" to people who don't have my work ethic. I'm tired of being told the government will take the money I earned, by force if necessary, and give it to people too lazy to earn it.

I'm tired of being told that Islam is a "Religion of Peace," when every day I can read dozens of stories of Muslim men killing their sisters, wives and daughters for their family "honour"; of Muslims rioting over some slight offense; of Muslims murdering Christian and Jews because they aren't "believers"; of Muslims burning schools for girls; of Muslims stoning teenage rape victims to death for "adultery"; of Muslims mutilating the genitals of little girls; all in the name of Allah, because the Qur'an and Shari'a law tells them to.

I'm tired of being told that out of "tolerance for other cultures" we must let Saudi Arabia and other Arab countries use our oil money to fund mosques and mandrassa Islamic schools to preach hate in Australia, New Zealand, UK, America and Canada, while no one from these countries are allowed to fund a church, synagogue or religious school in Saudi Arabia or any other Arab country to teach love and tolerance..
Maybe this has been around but thought it was worth a read.




I'm tired of being told I must lower my living standard to fight global warming, which no one is allowed to debate.

I'm tired of being told that drug addicts have a disease, and I must help support and treat them, and pay for the damage they do. Did a giant germ rush out of a dark alley, grab them, and stuff white powder up their noses or stick a needle in their arm while they tried to fight it off?

I'm tired of hearing wealthy athletes, entertainers and politicians of all parties talking about innocent mistakes, stupid mistakes or youthful mistakes, when we all know they think their only mistake was getting caught. I'm tired of people with a sense of entitlement, rich or poor.

I'm really tired of people who don't take responsibility for their lives and actions. I'm tired of hearing them blame the government, or discrimination or big-whatever for their problems.

I'm also tired and fed up with seeing young men and women in their teens and early 20's bedeck them selves in tattoos and face studs, thereby making themselves un-employable and claiming money from the Government.

Yes, I'm damn tired. But I'm also glad to be 76.. Because, mostly, I'm not going to have to see the world these people are making. I'm just sorry for

October 21 2011 at 9:33 PM Report abuse rate up rate down Reply
2 replies to hollytoky's comment
thompkinsmikey

He has excellent points. Too bad not many people will listen.

October 21 2011 at 11:12 PM Report abuse rate up rate down Reply
1 reply to thompkinsmikey's comment
johanbachura

What does this have too do with the topic?

October 21 2011 at 11:54 PM Report abuse +1 rate up rate down
kyotoai

Actually the author's name is Robert Hall. For some reason someone took material from his blog, credited it to Bill Cosby, and started passing it around the internet. Robert Hall's blog is here: http://tartanmarine.blogspot.com/2009/02/robert.html

October 22 2011 at 5:05 AM Report abuse rate up rate down Reply
bresl9

very interesting

October 21 2011 at 9:08 PM Report abuse rate up rate down Reply
lukedude27

My wife likes to shop. So its off to work I go. I can't picture myself retired. I will work until I die out of choice. I could'nt imagine a life where I did not get up and go out do something. There is plenty of time to rest when your dead.

October 21 2011 at 8:26 PM Report abuse -1 rate up rate down Reply
hackitoff

Target date funds, other mutual funds, stocks/bonds of specific companies, paid investment advisors, morning star or other rankings - it's still a crap shoot. No one knows where the market will be over the next year let alone the next 30-40 years. Buying a mutual fund based on past performance is one of the biggest mistakes an investor can make. You need to review before buying and at least several times a year after buying.

October 21 2011 at 8:14 PM Report abuse +1 rate up rate down Reply