4 Key Issues of Target Date Funds

Submitted by Rooz Eftekhari on Mon, 03/06/2017 - 13:51
Target_Date_Fund_Bullseye

Target Date Funds are all the rage now. The theory behind them is ease of investing. Their growth as an investment product has been attributed to their claim of simplicity. You just pick the date you want to retire, then put money in, and then pull out your money at the date you choose, normally around retirement age. Sounds great, but is it really that simple? Let’s take a look.

A Target Date Fund ("TDF") is a mutual fund made up of mutual funds, or a Fund of Funds (“FOF”). Fund of Funds have been available to investors for a long time. The theory behind TDFs is that the Fund of Funds will change its allocation based upon a Glide Path to retirement. So, if you are far away from retirement, presumably the fund has more equities and less fixed income products and the closer you are to retirement the fund has more fixed income products and less equities. This movement in allocation is the Glide Path. That actually doesn’t sound so bad, and is probably what most people do anyway. So where’s the catch?

 

1. GLIDE PATH

Target_Date_Funds_Glide_Path_Example

The most important or attractive feature of TDFs is the Glide Path. This is an asset allocation adjustment based on a time schedule that the fund manager follows, which typically moves from more aggressive investments to more conservative investments the closer you get to retirement. The schedule may be static or dynamic.  Generally the glide path will adjust till it reaches a “landing point” and then will be static after the landing point. Many funds have a landing point after the target date, and it could be even as far out as thirty years past the target date. The benefit is the convenience of not having to readjust your portfolio personally as it’s done for you in the TDF, and that’s a nice feature. The downside is that the approach may not address the challenges that can be presented in the real world.

As investors are different the most efficient glide path for one investor may not be the most efficient glide path for another investor. Investor’s suitability, objectives, asset mix, and risk tolerance will vary, so a one-size fits all approach may not be the right solution. If there is too much emphasis on returns then the risks involved may be higher, while conversely if too conservative there may be an increased risk of outliving the retirement savings. Changes in an investor’s financial situation, such as getting laid off, or an unexpected serious and costly health issue could have a significant impact. What if the target date you select ends up different from the date when you actually retire? The ability of a Target Date Fund investment to deal with such event risks remains suspect.

 

2. OVERDIVERSIFICATION

target_date_fund_structure

Is it possible to be over diversified? The short answer is, yes.  This could be at the point that the marginal benefit of risk reduction by an additional investment asset is lower than the loss of potential returns. Put simply there is only up to a certain level you can reduce risk and then there is no further benefit. The downside of over diversification is that you may reduce your ability to get returns, that are supposed to counterbalance or justify the risks you are willing to take.

Most TDFs are made up of other mutual funds and not direct fixed income or equities investments. Most TDFs have at least 10 mutual funds in the portfolio. What is less than attractive is the common practice that these 10 or more mutual funds are usually other funds from the same Fund Family (investment house) rather than a best in class mix.  

We can safely assume that most mutual funds have at least 20 holdings, with perhaps a greater concentration in 10 core holdings.  If the portfolios of the mutual funds are truly diversified and there are no overlaps between the holdings between the mutual funds, then theoretically you could own 200 positions or more. Assuming they are equal weighted, then your exposure to each position could be only 0.5% or less. Now let’s take the case of a 40 year old investor who wants to retire in 25 years in 2042. If the TDF is allocated 80% equities and 20% fixed income then you may have 160 equity positions and 40 fixed income positions. This means in the equity side of the portfolio you are taking on market risk, yet will be hard pressed to get better than market returns.  This is an example of over diversification. So it’s quite possible that in the years when you should be getting growth and capital appreciation you could have done just as well by buying an index fund for the equity side of the portfolio, with presumably lower costs. Many of the TDFs structures may be a way for investment houses to layer another fee on your portfolio, where in some cases you will have two layers of fees.  First you pay the fee for the Target Date Fund, and then you pay fees to the underlying mutual funds as well.

 

3. RISK MANAGEMENT

Target_Date_Funds_Glide_Path_Far_Landing_Point

Target Date Funds have no guarantee and there is no assurance that you will have sufficient retirement income at the target point. You can lose some or all of your investment. If you are unlucky enough to be retiring during a severe market downturn, you may be in for an unwelcome surprise as to what the performance of your Target Date Fund might be. During the Financial Crisis in the period 2008-2010 the volatility of most TDFs was higher than the historical volatility of an all-stock portfolio. Many of the funds with a near target date of only a year or two away suffered considerable losses. This should not be too much of a surprise.  All investments have risk and so do Target Date Funds.

A unique feature of the TDF, the Glide Path,  could also be problematic if you're not aware of the specific details of how your Glide Path is set.  During the Financial Crisis many TDFs that were at or near their target date  were still geared further out for their most conservative allocation in time, rather than at or near the target date.  In turn the portfolios still had high exposures to equities during the the Crisis, perhaps more than would be expected.  This may have been normal from the viewpoint of the TDF manager, but if an investor didn't realize that their most conservative allocation was at a later time, they could be in for a rude awakening. In 2008 a 2010 Target Date Fund of a major house fell over 30% and some as much as 40%. Imagine that you had $1 million to retire on and now you had $700,000 or less in savings.   It could have serious consequences for how you retire and even perhaps when.  What is important is for investors to be aware of the risks and features of their TDF. An issue though is that the transparency of the Target Date Funds is low, so having the right information takes more leg work to procure, and it's most probably not as easy as just selecting the year and forgetting about your investment.

 

4. TAX CONSEQUENCES

Investors that hold Target Date Funds in a taxable retail account, such as an individual, joint, or trust, will have to pay capital gains (or receive capital losses). Not only will investors pay the capital gains on the Target Date Fund in taxable accounts but also for each of the underlying mutual funds. In a year where the Glide Path changes the allocation,  the TDF will sell some underlying mutual funds and pass on gains/losses as the portfolio is adjusted for the new allocation. The dividends and interest income are passed through to investors as well, with the income likely being taxed as ordinary income. Target Date Funds are not able to reduce the taxable income they generate through tax-loss harvesting, since they do not control the tax consequences of the underlying funds that they own. It may not be the best idea to own a Target Data Fund outside a non-taxable account, such as an IRA, SEP, or in a company retirement plan like a 401k or 403b.

 

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