Target-date risks

Posted by on July 14, 2009 @ 9:14 am in Investing

Criticism of target-date funds is heating up in the aftermath of hearings by the SEC and the Department of Labor. But rather than illuminating the retirement investing problem, the discussion has only highlighted a yawning deficit in the public debate.

The first criticism of target-date funds is that they are too risky, particularly the 2010 funds for those approaching retirement, which fell sharply in the 2008–2009 market meltdown. Policymakers and commentators complain that the risks were too large. The Federal Thrift Savings Plan for federal employees is sometimes held up as a better model for the private sector. It had a 2010 fund that declined by a small amount.

This criticism of target-date funds is centered on short-term risk—and highlights a high level of risk-aversion among critics, as well as perhaps a lack of understanding about longer-term risks. The marketplace, however, is taking a different view. Most money managers begin with the view that older Americans have a sizeable portion of their wealth in an inflation-adjusted government-guaranteed annuity: Social Security. They must look at risk holistically, not just as the short-term market risk of a 401(k) account or IRA.

Moreover, it is well known that inflation risk and longevity risks loom large in retirement. One of the major costs in retirement, health care, has been soaring ahead of incomes for decades. Out-of-pocket health care costs are expected to surge even faster as Congress addresses the struggling finances of Medicare. The risk of inflation is substantial, especially with large federal deficits. Longevity continues to creep up slowly. In such an environment, retirement savings invested principally in Treasury bonds (yielding 3.5% today) or bank CDs (<1%–2%) won’t last long.

No money manager dedicated to the fiduciary protection of investors considers it wise to focus only on short-term market risk, especially for employees approaching retirement. The long-term risks are too grave. (In fact, from this perspective, the Federal Thrift Savings Plan seems too cautious. If there is one group that can take more investment risk, it is federal employees—with steady employment, above-average wages, and taxpayer-guaranteed pensions.)

A second criticism of target-date funds is that 401(k) investors don’t understand them. Here the lack of perspective is breathtaking. For several decades, the criticism leveled at 401(k) plans (and other forms of self-directed investing) has been that many Americans lack the skills to make informed choices and create a professional portfolio. Some of our own research at Vanguard has highlighted the problem. Now, with the introduction of target-date funds, inexperienced investors have a simple way to select a professionally managed portfolio that can be based on the year they expect to retire. They are better able to avoid important errors, such as investing too cautiously or too aggressively.

And yet—it is reported as news that such individuals don’t understand the portfolios constructed for them! It is circular reasoning all around. Target-date funds were designed precisely for individuals who don’t know what they’re doing.

A third criticism is that fund companies have crammed junky products into 401(k) plans. Under the law, however, the decision to add target-date funds to a retirement plan is first and foremost the employer’s decision. These employer decisions are governed by what is recognized to be one of the most comprehensive standards of fiduciary conduct—the Employee Retirement Income Security Act of 1974. In carrying out their ERISA fiduciary duties, employers in the marketplace today are making careful assessments of products, benefits, and risks for their 401(k) plans. They are a critical lynchpin in the system—and their fiduciary oversight role is too often downplayed.

Finally, there’s the trend to paint all target-date funds with the same brush—that they are all high-cost or poorly managed or too aggressive. Yet four out of every five dollars in target-date funds are managed by three of the world’s leading money managers (yes, including us at Vanguard)*. All of these managers have similar portfolios risks and allocations, and all three have exceptional reputations as investment managers. (By the way, so do many of the companies running the rest of the money.) Yes, there are some junky target-date funds. But headlines like “Most target-date funds well managed” won’t sell papers.

The real risk of target-date investing, of course, is not that asset values declined in 2008–09. In policy and media circles, focusing solely on such declines is a major investment error (just as it is for individuals investing their own savings). Rather, the real risk is that unsophisticated investors at retirement age will be persuaded by an imperfect public debate that their only recourse in retirement is to hold safe investments. In ten and twenty years, only then will the true risks of that advice become apparent.

For more on target-date investing, see the Washington, D.C., testimony of my Vanguard colleague and fellow blogger John Ameriks.

* Source: Strategic Insight.

Investments in target-date funds are subject to the risks of their underlying funds. The year in the fund’s name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in a target-date fund is not guaranteed at any time, including on or after the target date.


• All investments are subject to risk. Investments in target date funds are subject to the risks of their underlying funds. Investments in bonds are subject to interest rate, credit, and inflation risk.

• Past performance is no guarantee of future returns.

• Bank deposit accounts and CDs are guaranteed (within limits) as to principal and interest by the Federal Deposit Insurance Corporation, which is an agency of the federal government.

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