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The Pension Protection Act of 2006 single-handedly created target date funds as a global asset class, one which now commands a 20% to 25% share among public and corporate pension plans. In the United States, more than $2.5 trillion is invested in these types of funds by approximately 40 million people.
The Pension Protection Act of 2006 single-handedly created target date funds as a global asset class, one which now commands a 20% to 25% share among public and corporate pension plans. In the United States, more than $2.5 trillion is invested in these types of funds by approximately 40 million people.
Target Date funds have become the default option for most qualified plans in which an employee’s contributions go to the age-based funds. These funds are assigned a specific year in which you are expected to retire (i.e. 2045). The funds hold a mixture of stocks and bonds and auto rebalances to become more conservative the closer you are to retirement.
While this default option is certainly better than the previous one of cash, it still brings a risk of underperformance for many investors. We are going to look at the findings of a recent study by a professor of finance at Villanova university which uncovers some of the hidden flaws of this investment class.
Long-Term Underperformance
The study, which can be read here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3729750 found that the use of target date funds could lead to underperformance of 21% of a 50-year holding period.
Underperforming by 21% would impact the success of your retirement immensely.
High fees
Target date funds contain both direct and indirect fees (fees charged by the funds that the TDF invests into), and the transparency of the indirect fees is low.
Many TDF manages engage in fee-skimming by charging higher fees on the less observable, more opaque underlying funds.
Rabih Moussawi, an associate professor of finance at Villanova University, found that 37% of TDFs invest in more expensive classes of funds.
Lack of accountability
In the same study, it was found that investors do not punish the fund managers for underperformance by withdrawing money nor do they reward them for a good performance by investing more. Instead, funds receive a steady flow of monthly contributions, regardless of performance.
This lack of accountability is most prevalent in younger investors. A longer time horizon reduces incentives for investors to monitor their accounts because the payoff of the fund is so far in the future that it is not even worth thinking about.
This provides the fund manager with more opportunities to pout the funds interest ahead of the investors.
Conclusion
If you are invested in a target date fund within your 401(k) you may be leaving money on the table. It is important to sit down and review all of your investment choices to make sure your allocation is suited to your goals. If you would like a complementary 401(k) review, I would be happy to help. Schedule a call with me here.
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