Not All Target-Date Funds Are Created Equal

I want to dedicate this post to an article I read this Wednesday on CNNMoney.com. The story is so serious that I’m surprised it hasn’t had more coverage in the press. According to the article by Mina Kimes –“Target Funds Miss the Mark”-, target-date retirement funds have sustained significant losses in the last year due to their heavy exposure to stocks.
Why is this significant in a time of market meltdown? The answer is that these funds were not supposed to be so heavily invested in stocks in the first place. Target-date retirement funds are aimed at individuals saving for retirement. Their main characteristic is that they offer to adjust their investment mix as your retirement date nears, so that you’re less and less exposed to market fluctuations the closer you get to retirement age.

For instance, a person who is planning to retire 30 years from now would invest in a target fund called something like “Target Retirement 2040”. The fund would be investing mostly in stocks today, but then gradually switch the investment mix towards less risky assets, like bonds and cash.

On the other hand, a person intending to retire in the next couple of years would have chosen a fund called “Target Retirement 2010”, and should expect it to be mostly invested in bonds and cash by now. In this way, the money earmarked to finance retirement would be shielded from the disastrous consequences of a sudden market decline taking place when retirement is looming.

So much for the theory. According to Mina Kimes, the reality is that many target-date funds were overinvested in stocks at the beginning of 2008. The advent of the stock market crash caught the 60-year-old investors to whom these funds were marketed with an investment mix that would only have been fit for 30-year olds -who have plenty of working years in front of them to recover from these losses.

The article singles out two target-date funds that held a very risky asset mix given their target dates:

Fidelity Freedom 2010 Fund (FFFCX) is designed, according to the Fidelity website, “for investors expecting to retire around the year 2010”. The fund was 50% invested in stocks in March 2008, and more than 45% in December of the same year.

AllianceBernstein’s 2010 portfolio (LTDAX), was 57% invested in stocks in February 2008. According to its website the fund “gradually adjusts the strategy to a more conservative investment mix [so that as you move into retirement] your strategy becomes more focused on protecting principal and generating income”.

It’s no surprise, given these risky asset allocations, that the two funds lost 25% and 33% last year, respectively, even though their investors would have been planning to retire in less than a year from now.

It is worthwhile mentioning at this point that an investor will not typically need all the money in a retirement fund the year they retire, but will instead gradually draw down their assets during a period of 20 to 30 years –so that investors in these target-date funds will have time to recover part of their losses even after retirement.

It is also important to note that other target-date funds have been following much more sensible investment strategies given their investors’ ages. Both Wells Fargo’s Advantage Dow Jones Target 2010 (STNRX) and Deutsche Banks’ DWS Target 2010 (KRFAX) had the majority of their holdings in bonds at the beginning of 2008, and had significantly smaller losses of 11% and 4%, respectively, last year.

However, I can’t imagine how terrible it must feel to discover that, after doing your due-diligence and choosing a fund that promised to protect your retirement income, a large chunk of it has been lost in the stock market crash. I wouldn’t be surprised if, as a consequence, some of these investors had had to delay their planned retirement date.

I hope this article serves as a warning of the risks of leaving your investments in auto-pilot. Unless you’re only investing in index funds, it’s worth checking the speedometer from time to time.

See also Philip Moeller’s blog entry and this article from SmartMoney.com for more on this topic.

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