Review & Outlook

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Another Problem with Target Date Funds and “Automated” Investing

3 September, 2013 by Matthew O'Brien, Ph.D. in Commentary

In an earlier comment we noted a number of drawbacks with the investing strategy behind target date retirement funds.  I want to highlight an additional problem: many different target date funds with the same target date have drastically different asset allocations, while many funds with different target dates have identical asset allocations. Recall that a target date retirement fund is a kind of index-linked mutual fund that has an automatic “glide path” that shifts the fund’s primary allocation from stocks to bonds as the target date of retirement approaches.

 Target date mutual funds are surging in popularity, in large part because such funds are increasingly offered as the default option in corporate 401(k) retirement plans.  Federal regulators, who have encouraged this trend, like target date funds because they have the effect of boosting the amount that plan participants end up saving and they tend to reduce gratuitous fund trading, which drives up transaction fees and lowers investment returns.

In order to appreciate just how varied ostensibly similar target date funds are, consider the eight funds listed below with the target date of 2015.  (The data was compiled by the Wall Street Journal and Morningstar, as of April 2013).

 Not only do the fees levied by these funds vary drastically—the American Century LIVESTRONG fund is six and a half times more expensive than the Vanguard Target Retirement fund—but so do their equity and fixed-income allocations.  The Fidelity Freedom K is only 85% invested while the Vanguard and T. Rowe Price funds are 96% invested, and the Wells Fargo fund has just 31% in stocks while the T. Rowe Price fund has 61% in stocks.

Indeed, the T. Rowe Price 2015 fund’s asset allocation is much closer to the allocation of Vanguard’s Target Retirement 2025 Fund (VTTVX), than it is to the Wells Fargo 2015 fund.  According to its online prospectus, the Vanguard 2025 Fund now has a 70.07% stock and 29.90% bond allocation.

But now just consider a single fund manager, Vanguard, which offers numerous different retirement funds with target dates in five year increments.  Vanguard’s Target Retirement Funds 2040, 2045, 2050, 2055, and 2060 all have identical asset allocations of 90% in a domestic international stocks and 10% in domestic international bonds.  Why so many different target date funds with the same composition? In a word, marketing.  Investors like the idea that they are receiving customized attention, and a precise target date creates the impression of customization, even when they’re receiving mass market products whose differences offer no additional value.  Such marketing has a further unfortunate consequence: it teaches savers to expect more precision that is possible from an investment portfolio.

Although each target date fund is meant to provide an automatic diversified investment strategy, it’s evident that the task of picking among all these funds is anything but automatic.  It’s doubtful that the corporate sponsors of 401(k) retirement plans are aware of all these complexities when they hire 401(k) plan providers to make target date funds available to their employees.  This is one reason why we think that O’Brien Greene’s approach to managing corporate 401(k) plans is generally superior to automated target date funds.  By pooling employees’ retirement assets into a diversified portfolio of individual stocks and bonds, we can maintain a transparent and responsive asset allocation that fits the needs of the employee participants in the present market conditions.  Furthermore, we can offer individuals the economies of scale that are enjoyed by institutional investors, but while still avoiding the additional transaction costs that afflict owners of mutual funds.

 

Matthew O’Brien