A recent article in March of 2009 mentioned that almost a third of 401k plan contributions are going into target funds (also called lifecycle funds). That is an incredible amount of growth for these relatively new investment vehicles. Is this growth healthy? Are target funds prudent investments for all participants? Do plan participants truly obtain the optimum investment return with this vehicle and are target funds suitable for every participant? As plan sponsors and 401k consultants, we need to ask these and other very important questions.

One Criterion for Risk Tolerance

Target funds have a simplistic formula for determining risk tolerance; just tell them when you want to retire. For example, if you plan to retire in the year 2019 you should select a 2019 target fund. Easy, undemanding, and extremely poor investment planning. A 2019 target fund assumes that everyone with a ten year time frame before retirement has exactly the same risk tolerance and financial goals. Everyone. Is that true? Absolutely not. Is it good portfolio planning? No, it is not.

Common sense will tell you just picking a year to retire should not be the basis for constructing an investment portfolio. The most important information you need to know about a plan participant is their risk tolerance, not which year they plan to retire. As a financial advisor and 401k plan consultant, it is my ethical and legal obligation to know a clients risk tolerance before ever recommending an investment. Target funds assume everyone’s tolerance for risk is the same. This makes it easy from an administrative viewpoint but are you doing a good job for your 401k participants? Even more importantly, are you making the right ethical decision in offering an investment to your participants which ignores their individual risk tolerance?

I have written before how 401k plan sponsors need to find a way to discover the risk tolerance of each of their participants since this is the most basic requirement before offering any investment. Target funds, with their one size fits all approach, violates this rule in the name of simplicity. Not every 40 year old has the same risk tolerance or financial goals. This huge problem alone, in my opinion, is enough to make everyone think twice about this form of investment option.

Rebalancing in Down Markets

Target funds not only create the same portfolio for everyone that wants to retire in a certain year but also automatically rebalance the portfolio without regard to market conditions. If your target fund in 2008 lost value in the equity positions then it would rebalance by buying more stocks in early 2009 regardless of market conditions. This would compound the portfolio losses since you were buying more equities while the markets are still going down. You have no ability in target funds to move to a more conservative position and the actions target funds make while in a severe bear market will simply make your losses greater for your existing portfolio.

This non-thinking approach to market rebalancing is easy to administer since all portfolios automatically get rebalanced at the same time but it can be the worst decision to make based on what is happening in the market. This is another reason why making a financial product that is simple may not be in the best interest of participants.

Internal Target Fund Investments the Best?

Often the investments inside a target fund are mutual funds from the same fund company that created it. Is this impartial money management selection? No. It serves the mutual fund company well but what about the individual participants? Mutual fund companies are saying you can have any target fund investment manager you want as long as they are employed by our company and we get the fees for it.

Vanguard is usually accepted as shareholder friendly but in their target funds you only get Vanguard managers of generally passive investments. This helps Vanguard make money even if the management fees are low. A small percentage of billions of dollars will add up to millions in revenue for adding no value other than just tracking the index.

Even with index funds there are some companies who do a better job of tracking the index at a lesser cost. The problem is the lack of objectivity in selecting which managers will manage the target funds from these companies. If you have active managers the problem can be worse because I have never found one mutual fund company that has the best money managers in all asset categories. They will pick their managers because they make a profit by doing so not because they are necessarily the top managers. Is this the kind of motivation you want for the people who will select your money managers?

Asset Allocation Strategies Vary

How much should you have in stocks when you are 10 years away from retirement? Does retirement mean you should go to all cash or bonds? Should you hold REITS no matter what the real estate market is doing? Everyone answers these questions differently and therefore creates a different asset allocation to work with. Target funds are no exception but they take, in my opinion, the worst position.

Using our 10 years to retirement as an example let’s assume that for the first five years the stock market performance was awful. The target fund kept automatically rebalancing into declining stock values and lost more and more money. Five years from retirement the markets turned back around and soared but now, since we are close to retirement, the target portfolio is moving more to bonds and cash than equities. We are missing the opportunity to make some of our money back because of the target fund assumption we need to move to cash and bonds as we get closer to our target date. I can’t imagine much worse of a timing scenario for someone who is depending on this money for their retirement.

Putting your retirement plan on autopilot with a target fund and then hitting a market storm like 2008 reveals the fact that there is no human pilot to back it up. Even airplanes have a pilot just in case something goes wrong. Target funds are set up with the assumption that everything they do is ideal for your portfolio. That assumption can be appallingly wrong.

The Myth of the Automatic Portfolio

Plan sponsors, administrators, human resource departments and others who are involved in making decisions as to the composition of their 401k plan investments should stop dreaming of the perfect automatic portfolio for their participants. There is no such thing and never will be. There are too many variables in the market, the risk tolerance, and financial goals of your participants to ever come up with the perfect simple solution.

Target funds are not the cure-all and, in fact, can be harmful to your participant’s financial future. Investing is hard work. It takes time and effort. To provide the best retirement future for your participants your 401k plan will also require hard work and effort. What it is not is simple.

We have watched recently how the 401k plan wealth of our participants has lost trillions of dollars in value while they stood on the sidelines in shock. Those in target funds are getting hit even harder and yet we are recommending this convenient portfolio? There are better systems and more efficient ways to help your participants plan their retirement future. I have never recommended a target fund for any of my clients for the above reasons. We need to rethink our endorsement of this product, whether DOL approved or not, from the perspective of what is best for our participants. In my humble opinion, target funds should not be our future.

###

401khelpcenter.com is not affiliated with the author of this article nor responsible for its content. The opinions expressed here are those of the author and do not necessarily reflect the positions of 401khelpcenter.com.