Target date or retirement date funds (TDF) are commonly used by 401(k) retirement accounts for participants who either don’t know how or don’t want to bother with creating their own retirement portfolio. The concept is simple. Let an investment company create model investment portfolios for investors using their own mutual funds based on when the investor plans on retiring. So if you are 40 years old and plan to retire at 65 you would pick a 2035 target date fund. The fund sponsor would take care of your asset allocation by getting more conservative as retirement approached. The funds don’t mature on the retirement date, so an investor could keep their retirement funds in the same fund throughout retirement while making withdrawals for income.
So what could go wrong?
Target Date Funds Fee Confusion
Looking at the American Funds Group—a popular choice among commissioned investment reps—they have target date funds from 2010 to 2060 in five-year increments, based on when you might need your funds. For each target date, American Funds offers 13 different versions. All hold identical investments and only differ by the fees being charged. The highest fee choice, their “C” class shares, charge a 1.45% annual expense, a 1% annual 12b-1 fee (a marketing fee that is actually used to pay brokers an ongoing commission) and a 1% redemption fee if shares are sold within 12 months of purchase. On the opposite spectrum they offer an “F2” share class with a 0.42% annual expense or an “R6” (only available to retirement plans) with a .36% annual expense.
But don’t think it’s just the load funds that make things difficult. No-load favorite Fidelity Investments offers a similar target date range with their Fidelity Advisor Freedom Funds lineup. While American Funds may be the overkill champion, Fidelity does have four separate fee choices per fund for their advisor offerings. Ranging in expenses from 2.64% for their “C” class down to .64% for their “I” share class. Then there are two more choices for the regular Fidelity Freedom Funds with a .56% or .64% fee option. If you’re keeping track at home, that’s six different fee options for the same fund. Vanguard on the other spectrum only offers two fee choices, an institutional class for investors with over $100,000,000 to invest, and their investor class for the rest of us.
Target Date Funds Fee Duplication
If that isn’t confusing enough, target date funds are funds of funds that invest in a portfolio of mutual funds, not in stocks or bonds directly. This means that each underlying mutual fund also has its own expenses! For the American Funds group, all of their target date funds invest in a portfolio of American Funds mutual funds in the “R” fee class. For example American’s R6 class of their growth fund would add 0.46% to your expenses. The Fidelity growth fund found in many of the Fidelity TDFs adds another 0.74% of expenses to your investment. But each fund has their own fee schedule. These fees would tend to be higher for longer-dated funds that are more aggressive and lower for less aggressive nearer-dated funds. Added together, the average expenses among target date funds comes in around 2%. (For related reading, see: The Pros and Cons of Target Date Funds.)
Risk and Past Performance of Target Date Funds
One of the largest attractions to these funds, for the fund company as well as for the investor, is that by virtue of their diversified holdings they should manage the market risk to the investor. Let’s take a closer look. While past performance is not a guarantee of future results, looking at how a portfolio behaved during a specific time frame is a useful exercise in building client portfolios. If we look at the financial crisis from October 2007 to February 2009, the S&P 500 dropped 50.17%. By comparison, American’s A share 2010 target date fund lost 36.35%. Significantly less than the S&P 500, but if you owned a fund designed for someone retiring in less than a year, would you be satisfied with “just” a 36% loss right before retirement? Fidelity Freedom 2010 lost a similar 31.42% during the same period. Vanguard’s 2010 lost 29.02%. Let me put this into real numbers to digest. Joe (a hypothetical person) had $500,000 of his 401(k) plan invested in the Fidelity Freedom 2010 fund on September 30, 2007 and was planning to retire on January 1, 2010. On February 28, 2009, eight months prior to retirement, his account balance was approximately $340,000 (plus any additions added). I’ll let you decide if that is what you would consider to be good risk management. (For related reading, see: Why You Should Be Wary of Target Date Funds.)
For an investor looking to retire in 2035, 28 years after the financial crisis, the Fidelity Freedom 2035 Fund dropped 47.80%. Not much better than just holding the S&P 500. But certainly an actively managed fund holding funds chosen by Fidelity would outperform the S&P 500 over the longer term. Not necessarily. The 10-year average annual return as of October 31, 2016 of the S&P 500 is 6.70%, while the Fidelity Freedom 2035 Fund’s average annual return has been 4.43%. American Funds does not have a 10-year average annual return figure.
Bottom line – longer dated funds seem to have a substantial risk profile, similar to the S&P 500, with significantly lower average annual returns. While an index fund has minimal fees to the investment company, many target date funds double-dip on fee collection by charging for the target date fund and for the underlying funds. So who is making money here? (For related reading, see: Should I Ditch the Target Date Fund?)
While this report doesn’t cover all aspects of target date funds, my conclusion is pretty clear. The risk reduction offered by TDFs is greatly exaggerated and does not come close to offsetting the probable lower capital accumulation that is likely versus investing in an all-equity portfolio that can reasonably be expected to meet or exceed the total return of the S&P 500 index.
The opinions expressed are those of Bill DeShurko. Past performance is not a guarantee of future success. Consider all risks before investing and it is always advisable to consult with a professional before making investment decisions.
*Data quoted is from www.steeleSystems.com Original base data provided by Morningstar, Inc.