Lily Tomlin, comedienne, actress and writer/producer once suggested something about target date funds – although she wasn’t speaking about them directly; but she very well could have – saying, “Don’t be afraid of missing opportunities. Behind every failure is an opportunity somebody wishes they had missed.” Target date funds are a basket of missed opportunities wrapped in a potential failure, gift wrapped with hope.
For those of you who are unaware of what these investments are, I’ll explain. Ironically and the chances are very good that even as you don’t know what they are, you might even own them. In a great many instances, they have become the auto-enrollment darlings of your 401(k) plan. They offer a solution to the fiduciary problem that many 401(k)s were facing: how to get workers in their employ to invest. In a previous time in the not-too-distant past, the plan sponsor cared but it wasn’t evident in where they put your money if you opted to be auto-enrolled. This is actually something a few businesses without being told to do but did but did poorly. Money market accounts were often where this money that they signed you automatically up for at your job orientation, we found out often later than sooner, hardly provided the best way to get you to a retirement.
So when the Pension Protection Act of 2006 was passed, the target date fund was dragged from the background and placed in the forefront of your portfolio choices. The idea is simple enough. You buy a fund based on the potential year you will retire. The fund – in theory – gradually rebalances your assets in the fund to reflect your age, going from somewhat risky to somewhat conservative over the length of your career.
This gives most people a set-it-and-forget-it mindset that is hard to break. But worse, these funds may not be doing what they should be doing. And even worse, you have almost no way of telling whether the fund is what you need in large part because you aren’t too sure of what you need either. Sound confusing? It gets more complicated.
Take for example two 40-year old men. One is a professor at a mid-sized private college and the other is employed in a blue-collar job. Both think they’d like to retire at 65. Both buy the same target date fund with a potential year of retirement attached. In this case, it might be a 2035 fund.
But the difference between the men cannot be tracked by the fund. One will definitely be able to continue working well past age 65, even if that is when he would like to retire. The professor understands the demands of his job, the human capital that he exerts on a daily basis that does little to prohibit him from continuing on for 10, perhaps 20 years past the target. He understands but his target date fund does not.
It is not the same with the blue-collar worker. 60-five is 60-five. In many instances, this worker’s career-long exertion of human capital over that same 25 years will leave this target date fund owner looking forward to the last day on the job. And although this person feels pretty good at 40-years old; he knows life at 65 will be different. He knows that there might not be any energy left to keep working. This workers human capital will be spent by the time they reach 65, not allowing them to continue at all.
Which worker is not served well by the target date fund with a potential retirement date of 2035? As it seems to be our custom, we asked Larry Swedroe, author of The Quest for Alpha about target date funds, a question we seem to ask every investment professional when they come on my weekly radio show Financial Impact Factor. Larry answered the question with great skill all-the-while giving us something else to ponder.
We know that target date funds can be a mash-up of poorer performing funds, orphan funds and several other funds that may or may not be actively managed. We knew that they have a relatively short track record and a history for being unable to pin down where in the process of asset allocation the fund is at any one point in time. It is even difficult to determine any predictable investment style. One fund might be 60/40 stocks to bonds at one point in time while another fund with the same target date might be 40/60 stocks to bonds.
We also know that they have not performed all that well in the short-term. This is particularly alarming for folks who gathered their downturn-damaged portfolios and rolled them into these funds, hoping for some recovery, some protection. In many instances, they received neither.
The best remedy we decided was not much of one at all and in truth is still evolving. You could extend your target date out further if your profession isn’t physically taxing and possibly lends itself to a longer working career and by default, a longer investment horizon. You could, on the other hand, educate yourself a little better. You could load your retirement account up with index funds spread across all sorts of sectors.
The idea of target date funds isn’t necessarily a bad one. But the concept needs more academic research. And despite reams of studies about every other facet of the industry, this one is curiously missing.
And as we have suggested, a missed opportunity could lead to future failure that some of us might not have anticipated.