By Bill DeShurko
Let me count the ways…
What are they?
Target Date or Retirement Date Funds (TDF) are used by 401(k) retirement accounts for participants that either didn’t know how, or didn’t want to bother with creating their own retirement portfolio. The concept is simple. Let an investment company, like Fidelity for example, create model investment portfolios for investors using their own mutual funds based on when the investor plans on retiring. So if you are 40 years old, plan to retire at 65 you would pick a 2035 Target or Retirement date fund. The fund sponsor would take care of your asset allocation, by getting more conservative as retirement approached. The funds don’t “mature” on the retirement date, so an investor could keep their retirement funds in the same fund throughout retirement while making withdraws for income.
Recently the Department of Labor passed what is commonly called “The Fiduciary Rule” which applies to all types of investment advisors, both commissioned and fee based when it comes to managing all retirement accounts including IRA accounts. Previously the Fiduciary Standard only applied to employer sponsored plans, not IRA’s. Fee advisors have a fiduciary standard for all client accounts, whereas brokers (commissioned accounts) only needed to be managed to a “suitability” standard. Confusing stuff, and more can be read here and here if you are not familiar. But the end result is that brokerage firms have been forced to assume more legal liability that comes with a higher investment standard for their clients. Despite what you might believe (that the brokerage firm’s primary interest is to make you money), their primary goal is to gather “sticky” assets (those that stick with the firm generating long term fees), and avoid legal costs. TDF’s fit the bill. As a result investors are likely to be recommended that more and more of their IRA assets be put into Target Date type funds. In theory, TDF’s, due to their diversified nature should produce steady if unspectacular results. But that is a good thing, especially when “spectacular” refers to “spectacularly bad”!
So What Could Go Wrong?
Fee Confusion. Looking at the American Funds Group, a popular commission (or load) based mutual fund family, they have Target Date funds from 2010 to 2060 in five year increments, based on when you might need your funds. While retirement is the primary use, target date funds are also a popular choice for college savings 529 plans. For each target date, American Funds offers 13 different versions! All hold identical investments and only differ by the fees being charged. The highest fee choice, their “C” class shares charge a 1.45% annual expense, a 1% annual 12b-1 fee (a marketing fee that is actually used to pay brokers an ongoing commission) and a 1% redemption fee if shares are sold within 12 months of purchase. On the opposite spectrum they offer an “F2” share class with only a .42% annual expense or an “R6” only available to retirement plans with a .36% annual expense.
But don’t think it’s just the load funds that make things difficult. No-load favorite Fidelity Investments offers a similar target date range with their Fidelity Advisor Freedom Funds lineup. While American Funds may be the overkill champion, Fidelity does have four separate fee choices per fund for their Advisor offerings. Ranging in expenses from 2.64% for their “C” class down to .64% for their “I” share class. Then there are two more choices for the regular Fidelity Freedom Funds with a .56% or .64% fee option. If you’re keeping track at home, that’s six different fee options for the same fund. Vanguard on the other spectrum only offers two choices, an institutional class for investors with over $100,000,000 to invest, and their investor class for the rest of us.
Fee duplication. If that isn’t confusing enough, Target Date Funds are funds of funds that invests in a portfolio of mutual funds, not in stocks or bonds directly. This means that each underlying mutual fund also has its own expenses! For the American Funds group all of their Target Date Funds invest in a portfolio of American Funds mutual funds in the “R” fee class. For example American’s R6 class of their Growth Fund would add .46% to your expenses. The Fidelity Growth Fund found in many of the Fidelity TDF’s adds another .74% of expenses to your investment. But each fund has their own fee schedule. These fees would tend to be higher for longer dated funds that are more aggressive and lower for less aggressive nearer date funds.
Risk, Past Performance. One of the largest attraction to these funds, for the fund company as well as for the investor, is that by virtue of their diversified holdings they should manage the market risk to the investor. Let’s take a closer look. While “past performance is not a guarantee of future results”, looking at how a portfolio behaved during a specific time frame is a useful exercise in building client portfolios. If we look at the financial crisis from Oct 2007 through February 2009 the S&P 500 dropped 50.17%. By comparison American’s A share 2010 target date fund lost 36.35%. Significantly less than the S&P 500, but if you owned a fund designed for someone retiring in less than a year, would you be satisfied with “just” a 36% loss right before retirement? Fidelity Freedom 2010 lost a similar 31.42% during the same period. Vanguard’s 2010 lost 29.02%. Let me put this into real numbers to digest. Joe (a hypothetical person) had $500,000 in his 401(k) plan on September 30, 2007 invested in the Fidelity Freedom 2010 fund, planning to retire as on January 1, 2010. On February 28th of 2009, eight months prior to retirement his account balance was approximately $340,000 (plus any additions added). I’ll let you decide if that is what you would consider to be good risk management.
On the longer end for an investor looking to retire in 2035 28 years after the financial crisis, the Fidelity Freedom 2035 Fund dropped 47.80%. Not much better than just holding the S & P 500. But certainly an actively managed fund, holding funds chosen by Fidelity would outperform the S&P 500 over the longer term. Not necessarily. The 10 year average annual return as of 10/31/2016 of the S&P 500 is 6.70%, while the Fidelity Freedom 2035 Fund’s average annual return has been 4.43%. American Funds does not have a 10 year average annual return figure.
Bottom line – longer dated funds seem to have a substantial risk profile, similar to the S&P 500 with significantly lower average annual returns. While an index fund has minimal fees to the investment company, many target date funds double dip on fee collection by charging for the target date fund and for the underlying funds. So who is making money here? And why is the Department of Labor (DOL) seemingly pushing investors into these funds?
Future Performance. No I don’t have a crystal ball, but what we do know is this:
- As of December 2016 interest rates on the 10 year Treasury have risen nearly a full percentage point since the election.
- The Federal Reserve has wanted to move rates from the zero level for years.
- Mr. Trump campaigned against the Fed disrupting the economy by keeping interest rates low.
- Bonds allocations increase in TDF’s as the target or retirement date gets closer.
- Bonds lose money when interest rates go up.
To sum that up, target date funds intentionally buy investments that mathematically lose value (assuming rising interest rates), as the investor moves closer to retirement.
How much can you lose? Whenever looking at individual bonds, bond funds or ETF’s there is a statistic call “Duration” that is usually reported. The actual definition and calculation is a bit confusing, but duration is commonly used as a proxy for the funds likely price change from a 1% change in interest rates. For example the duration for the bond holdings in Fidelity Freedom 2035 Fund is 4.13 and they hold only 3.50% of assets in U S bonds. So any change in interest rates would have only a nominal effect on the overall fund performance. But in the 2020 Fund, targeted at someone just 3 years away from retirement the duration is 5.16 and they hold 26.30% of assets in U S bonds. This means a loss of 1.3% to the portfolio if interest rates rise by 1%. This may not seem like much, but add in the Funds expenses of .67% and the underlying fund expense of .45% and the interest from the bond holding of 3.73% is nearly wiped out. The conundrum, and in fairness all investors currently face, is that by diversifying into bonds as you approach retirement you are at best creating “dead” assets with very little potential for a positive return. But stay too heavy in stocks and you face the potential catastrophic losses that investors, including those in target date funds, suffered in the financial crisis.
Of course the bottom line to most investors is performance. And when it comes to long term investing for retirement that should be an investor’s priority. Volatility is not pleasant, and can destroy a retiree’s portfolio when distributions are being taken from a falling portfolio. But for the accumulator, long term return is what matters.
TDF’s have short track records, but both Fidelity Freedom Funds and the Vanguard Target Retirement funds do have at least a 10 year track record. While I think focusing on fees only is a pretty lazy approach to analysis, it’s also pretty clear that Vanguard’s performance advantage comes from their low fee structure. Vanguard’s Target Retirement 2045 Fund has a 10 year average annual return of 5.32% and a financial crisis loss of 46.68%. The Vanguard S&P 500 Index Fund has a 10 year average annual return of 6.58% and a financial crisis draw down of 50.20%. While the returns aren’t too exciting for either it would be a mistake to dismiss the difference.
Taking a simple example of someone with $20,000 invested and adding a flat $5000 a year for 30 years until retirement. At a 5.32% average annual return for 30 years our investor would accumulate $466,350. Up that to 6.58% and the amount would be $611,000, that’s 31% more by sticking with the index fund. In theory that gap would actually be larger as the target date fund would gradually move to a higher bond allocation as the target date grows closer, reducing the risk level but also reducing the average annual return.
While this report doesn’t cover all aspects of Target Date Funds, my conclusion is pretty clear. The risk reduction offered by TDF’s is greatly exaggerated and does not come close to offsetting the probable lower capital accumulation that is likely vs. investing in an all equity portfolio that can reasonably be expected to meet or exceed the total return of the S&P 500 index.