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The Problem with Target Date Funds Thumbnail

The Problem with Target Date Funds

Target date funds, the most prevalent 401(k) investment option, are producing ineffective investment results for millions of Americans

401(k)’s are one of the most popular retirement saving vehicles for Americans. However, most of these accounts are being inefficiently invested leading to underperformance over the long term, ultimately leaving individuals with less money for retirement. The Bank of America (BOA) securities group released a study earlier this year analyzing target date funds, which account for 42% of 401(k) assets, or $3 trillion. They analyzed the performance of these funds over nearly 30 years and found that they have underperformed the S&P 500 by 2.4% annually. 

What is a target date fund? 

Target date funds, or life cycle funds, are funds in which the asset mix changes over time as you approach retirement. For example, if one planned to retire in 2040, they would invest in the 2040 target date fund. This fund would initially invest relatively aggressively before shifting to a more conservative portfolio as the investors near retirement age. Many consider these as ‘set and forget’ funds, but BOA’s study shows the problems that this strategy yields. 

Target date funds are supposed to give investors peace of mind, with a higher equity allocation in the early years and a more conservative, fixed-income allocation as investors near retirement. The funds are built to sacrifice some return for a lower risk level, but the BOA study found that these funds exhibited similar volatility as the S&P 500 while lagging performance by 2.4% annually. Therefore, they are taking unnecessary risk and not being rewarded with returns. The study shows that a simple 60/40 asset mix would have produced better results than a target date fund. So, why are these most popular funds underperforming?

Why have target date funds underperformed?

The head of the BOA study, Jared Woodward, gave three main reasons these funds have underperformed over the last 28 years: 

1.    International Exposure – Target date funds can have a large allocation of up to 30% in international equities at any time. Some international exposure is good, but Europe and Japan have lagged the US considerably over the last 15+ years, so this is one driver of underperformance. Additionally, target date funds act like indices, and buy entire stock markets. Within these slower growth economies, like Japan and Europe, it’s better to be flexible and buy the best companies rather than buying the entire set to help optimize the overall return. Overall, these observations demonstrate the lack of flexibility these funds inherently exhibit. 

2.    Bond Allocation – Target date funds provide exposure to bonds, which traditionally have negative correlation to equities, but this relationship has been tested in recent years. Furthermore, these funds typically invest only in treasury and high-quality bonds, which have suffered greatly in the recent low-rate environment years. Investors should diversify their bond exposure to include, for example, higher yield bonds with some credit risk to allow for a positive return or TIPS to protect investors against inflation. Once again, target date funds' lack of flexibility hurts investors by leaving them invested in unfavorable assets. 

3.    Rigid allocation and Rebalance rules – The third point wraps up the issues as evidenced above, target date funds are run by a rigid set of rules and therefore are not flexible. When economic conditions change or trends are foreseen, it’s improbable that these funds can adapt to take advantage of the changing conditions. Having funds with a strict set of rules and parameters in a world and economy that changes ever so rapidly leads to lagging investment performance over the long run. 

How we can help

The positive news is that at Cunningham Wealth Management we have the right tools to help you optimize your 401(k) and other retirement saving vehicles. We recently announced a partnership with Pontera, that allows us gain insight into your 401(k) and help you invest your retirement funds properly. We can now look at your investments as a whole and choose the right funds for you in accordance with your goals and risk tolerance. Pontera also recently released a study showing that managed retirement accounts outperform unmanaged accounts by 3.32% annually, so even if you are not invested in target date funds, professional management can make a material difference to your retirement accounts. If you would like to setup a call to discuss how we can help with this, please follow this link.

In recent communication, we announced our partnership with Dimensional Fund Advisors. We understand the problems with ‘set and forget’ investments, and Dimensional provide a more active approach. This means we can provide you with a low cost, diversified portfolio, but Dimensional will act and take advantage of opportunities in the market to achieve higher returns, rather than follow rigid rebalancing rules. To discuss your portfolio, you can set up a call with this link.