Are Target-Date Funds Missing The Mark?

By Brian O'Connell

Financial advisors are well aware of so-called target-date funds – also known as lifecyle, age-based, or “set it and forget it” funds.

These funds automatically reset the asset mix of stocks, bonds and cash equivalents in a client’s linked to a predetermined time frame.

While highly popular, target-date funds are coming under some increased scrutiny of late, as market watchers say the set-it-and-forget-it portfolio management philosophy may be off target.

The recently-released MFS Defined Contribution Investment Trends Study
notes that many plan sponsors are focusing too much of short-term performance, and not enough on risk and asset allocation issues, all at the detriment of clients.

"Many sponsors have succumbed to short-term pressures - and these are often misaligned with the long time horizons of plan participants," says Ryan Mullen, senior managing director and head of MFS' Defined Contribution Investments practice. "The effectiveness and skill of an investment manager can only truly be judged over a full market cycle, which is longer than three years."

The study notes that 66 percent of financial professionals surveyed say investment performance is a big priority in choosing specific target funds. (Fees are the second biggest priority, MFS reports.)

"Plan sponsors tend to focus on performance as a key indicator of successful retirement outcomes," said Ravi Venkataraman, global head of consultant relations and defined contribution at MFS. "But the importance of asset allocation and risk management in driving performance is often overlooked. And as we saw during the global financial crisis, these factors can have an outsized impact on the performance of a target date portfolio."

'Wide Misuse'

Another brand new study, this one from Financial Engines, goes even deeper, noting a “wide misuse of target date funds driven by investor overconfidence.”

According to Financial Engines, only 26% of investors are “using the funds as intended,” citing “overconfidence” as a chief culprit.

“While the ‘set it and forget it’ promise of target-date funds is appealing to some investors, most participants don’t forget it -- they are actively investing away from the target-date fund in their portfolios,” notes Christopher Jones, chief investment officer of Financial Engines.

“Based on behavior patterns of participants analyzed in this research, expecting most participants to stay put in a target-date fund over their working careers is simply unrealistic," Jones says. "These findings have clear implications for the long-term ability of target-date funds to impact retirement outcomes in defined contribution plans.”

The criticism of target-date funds comes at a time when such funds are pervasive, and are performing reasonably well. As a benchmark, target-date funds have returned 11.7 percent over the past three years and 9.3 percent over the past five years.

Even so, that criticism is merited, if you ask some financial advisors.

“There are a couple reasons that target day funds make very poor investments for the vast majority of people,” offers Eric Sajdak, chief investment officer at Fox River Capital, in Appleton, Wis.

First, such funds aren’t specific to the individual. “Target day funds put every investor on the same exact allocation schedule regardless of when that person’s retirement age is, the size of their retirement portfolio, or the goals of the investor,” Sajdak says. “True financial planning requires an element of specialization to the individual. Target days fail in providing this exerience.”

Date Is A Big Target

Robert R. Johnson, President and CEO of The American College of Financial Services, in Bryn Mawr, Pa., says that as with most simple solutions, there are issues with target date funds. “Target date funds are certainly not appropriate for all investors,” he says. The "one size fits all" approach of the target date fund implicitly assumes that every investor with a specific target date will have the same risk tolerance. As we know, that is simply not the case. Some investors will have a much higher risk tolerance and can adopt a more aggressive asset allocation. While other investors are much more risk averse and should adopt a more conservative asset allocation.”

Another major problem of target date funds is that they don't consider assets outside the target date fund. “In other words, if an investor has another large, steady income source - for instance a defined benefit pension plan from a previous employer - that investor would likely want a more aggressive asset allocation than the target date fund provides,” Johnson adds.

Toss in the fact that set-it-and-forget-funds don’t take into account changes in life circumstances that may impact an investor's long-term asset allocation decision, as Johnson points out, and you wonder why target-date fund investors are so overconfident in the first place, decent returns notwithstanding.

Now, with the spotlight shining harshly on such funds, more investors may take a longer look at target-date funds, and pass in favor of a more hands-on approach.

Brian O'Connell is a former Wall Street bond trader and author of the best-selling books, such as The 401k Millionaire. He's a regular contributor to major media business platforms. He resides in Doylestown, Pa. Brian may be reached at [email protected].