Tips on Target Date Funds (from WSJ)

If you’ve been following our posts, you know TDFs are a “buzz investment” right now. This article from the WSJ sheds some light on which TDFs are worth the buzz.

– Eric

A Wish List for Retirement Funds

Target-date funds continue to rise in popularity as the simple choice for any retirement account, and in many cases, they are a perfectly decent option.

But they could be a lot better.

The funds promise a changing mix of stocks and bonds tailored to your expected retirement date. But as many investors have found, some tilt heavily toward stocks even as retirement nears, increasing the risk of big losses at a crucial juncture. And there are other issues, such as the funds’ expenses and their underlying investments.


Keep an eye on how much of your target-date fund is invested in stocks, as well as how investments have changed. This year, for example, some fund firms have been increasing their foreign-stock holdings and decreasing domestic stocks

Assets in target-date funds climbed to $370 billion at the end of the first quarter, up from $340 billion at the end of 2010, according to the Investment Company Institute, a trade organization. Most of that comes from 401(k) and other “defined contribution” plans, where more and more companies are automatically enrolling new employees and depositing their savings in target-date funds.

Since the funds often are the default choice for our retirement money, here is an investor’s wish list for improvements.

Give us real diversification, not the kitchen sink.

Sure, you need a mix of stocks and bonds, with domestic and international flavors. But do you need everything on the buffet? In Fidelity Investments’ Freedom Funds, which hold about $115 billion, the portfolios include at least 20 mutual funds.

Such a glut of options may well muddy the results. “It’s impossible not to have a great deal of overlap,” notes William J. Bernstein, author of “The Investor’s Manifesto.” In the Freedom 2025 portfolio, for instance, five underlying funds own Exxon Mobil, Citigroup and Microsoft.

Fidelity manager Chris Sharpe says the nine equity funds in the 2025 portfolio are intended to ensure that shareholders participate in each sector. The overlap, he says, means investors are more heavily invested in stocks that Fidelity managers think will outperform. Even so, Morningstar calls the three-star fund merely “good enough.”

Make better use of index funds to lower expenses.

Outside of Vanguard Group, few big target-date funds make much use of low-cost index funds, relying instead on actively managed funds with higher expenses. Between 80% and 90% of the funds in T. Rowe Price‘s stock-heavy portfolios are actively managed, about the same as for Fidelity. Their expense ratios average more than 0.7%, or more than $70 per $10,000 invested, considered reasonable for target-date funds, but higher than investors might pay if they designed their own portfolios.


“The cost structure can be bloated when they don’t use the most-efficient funds,” says Craig Israelsen, a professor at Brigham Young University who has studied portfolio diversity.

T. Rowe Price notes that its U.S. stock mix has beaten the Standard & Poor’s 500-stock index over three years and five years, though it has underperformed in down markets.

“I don’t buy into ‘cheaper is better,'” says T. Rowe target-date fund manager Jerome Clark. “Our investors are getting more than what they pay for.”

Put the best-priced funds in the portfolios.

Fidelity introduced a “K class” of target-date funds two years ago, which has expenses that are about 0.1 percentage point lower for large plans. But many fund firms don’t offer such an option, even though the money comes from retirement plans in bulk.

Vanguard, with about $91 billion invested in target-date funds, uses regular Investor shares, rather than the lower-cost Admiral shares. An investor with $50,000 in its 2025 Target Retirement fund pays 0.18%, or $90 a year, in expenses, but would save more than $30 if he created a similar portfolio with Admiral shares, though he wouldn’t get automatic rebalancing. Switching to Admiral shares in that fund would cost Vanguard about $10 million in annual expense revenue.

Vanguard says its funds are run at cost, and many target-date accounts are small and wouldn’t qualify for Admiral funds, which generally require a $10,000 minimum investment.

If you are relying on target-date funds for your retirement, here is what you can do to try to improve your options.

• Ask your company, the plan sponsor, to seek lower expenses or better funds. Some very large companies are devising custom target-date portfolios with top funds from several companies, a trend that is expected to grow.

• If your retirement plan offers index funds, you can easily build your own simple portfolio of domestic and foreign stocks and bonds by mimicking what is in the Vanguard target-date funds, potentially saving a bundle on expenses over time.

• Keep an eye on how much of your target-date fund is invested in stocks, as well as how investments have changed. This year, for example, some fund firms have been increasing their foreign-stock holdings and decreasing domestic stocks.

Since funds vary in composition, Prof. Israelsen suggests that all investors in their mid-50s meet with a financial adviser to review how much they have saved and decide on an appropriate portfolio mix for the home stretch into retirement.

About thebenefitblog

Eric is a Producer at Lockton Insurance Brokers, Inc., the world’s largest privately held commercial broker. Eric has over 23 years of experience in the insurance industry and has spent the last 11 years with Lockton. Eric specializes in Health & Welfare Benefits, Retirement Planning, and Executive Benefits. Eric's clients utilize his expertise in the areas of Plan Due Diligence, Transaction Structure, Fiduciary Oversight, Investment Design, Compliance and Vendor negotiation to improve the operational & financial outcome for each client. The Benefit Blog is a place to share that expertise and industry news.
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