Mutual fund datapoint of the day

By Felix Salmon
June 25, 2009

Leslie Wayne reports:

As the stock market plummeted last year, some 2010 funds — which many investors thought would be invested safely by then to protect their nest eggs — lost 40 percent of their value. That showing was even worse than that of the Standard & Poor’s 500, which fell 38.5 percent.

Clearly, these target-date funds — which are likely to become much more popular if and when the Obama administration enacts opt-out rules for 401(k) contributions — could do with a bit of regulation: many of them seem to be designed to maximize fund-management fees, through a fund-of-funds structure, while doing very little to actually reduce risk as the target date approaches.

But who’s going to regulate these funds? They seem to lie outside the narrow remit of the Consumer Financial Protection Agency; while they might be looked at by the Financial Consumer Coordinating Council, which is a committee including the CFPA, it’s unclear whether the FCCC will have any teeth at all.

I hope that Wayne continues to report this story, and asks giants like Fidelity and AllianceBernstein why their 2010 funds were 50% and 57% in stocks, respectively, over the course of 2008. But for real regulation of these beasts, I think the SEC is our only hope. The good news is that Schapiro is on the case. The bad news is that she’s asking “whether it is necessary to improve SEC regulations to address any deficiencies with respect to target date funds”. In other words, she doesn’t have the requisite teeth yet, and it’s unclear whether Congress is minded to give her those powers.

Update: ajw, in the comments, finds one official rationale for keeping target-date funds overinvested in equities: that the idea is for the investors in these funds to hold on to the funds even after they have retired, rather than selling them for cash or converting them into an annuity or something like that. So retirement could, on this view, be decades before you actually need the funds. As ajw notes, this is self-serving and unconvincing.


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Love the world!!!!

A couple of years ago the investment industry began to realize that retiring baby boomers were viewing these funds as vehicles for asset accumulation, with the logical result that they would redeem their shares when they retireed. This would of course be a disaster for the fund managers. Around 2006, the smarter ones like AllianceBernstein started producing research showing how retirees who didn’t keep at least some of their assets in equities (which, wonder of wonders, have higher fees) would fall short in retirement. The argument was used to support the shift of these funds from vehicles for building assets for a targeted retirement date, to vehicles for people retiring on a certain date but still likely to live for a while and thus in “need” of a one-stop diversified fund that also includes more equities.

In other words, it was about keeping higher-fee assets in the door at rollover time. So there is plenty of research to support what the fund managers are doing, but it’s not clear that the funds’ names mean what they imply.

Posted by ajw | Report as abusive

“The argument was used to support the shift of these funds from vehicles for building assets for a targeted retirement date, to vehicles for people retiring on a certain date but still likely to live for a while and thus in “need” of a one-stop diversified fund that also includes more equities.”

Clearly, people expecting that need would just choose a later-dated target date fund.

Posted by Jon H | Report as abusive

I assumed that it was just performance chasing. The way to make your 2010 “better” than another 2010 fund was to take more equity risk … or to use the EMH mindset to reap the equity premium.

I haven’t followed the link yet, but have education target date funds done as badly? I’d assume so, with the corresponding sad stories.

Given the recent market turmoil and its impact on all retirement plans, we welcome the current examination of how target date funds are constructed, used, and understood. Target date funds provide a convenient way for an investor to purchase a mix of asset classes, within a single fund that rebalances its asset allocation and becomes more conservative as the investor ages. They are designed to avoid extreme asset allocations often observed in retirement accounts—the 25-year-old holding all cash, or the 60-year-old fully invested in equity funds. Just like “growth” funds or “value” funds, target date funds are not all the same. Some providers design their target date funds to reach their most conservative asset mix at or shortly after the target date. These funds place a higher priority on producing immediate income and preserving assets at retirement age. Many other providers design their target date funds to reach their most conservative asset allocation 10 or 20 years, or even longer, after the target date. This recognizes the fact that for many people, the end of your working life does not mean the end of your investing life. If you plan for 20 or more years of retirement, portfolio growth is important to generate income later in retirement. It is important that employers and investors understand the features of the target date fund they are considering.

Not all target date funds are mutual funds, but those that are are fully regulated by the SEC. Further, an employer’s decision to offer any target date fund to its employees is governed by ERISA, the federal law regulating employee benefits. The Investment Company Institute, the mutual fund trade association, agrees that it is important to enhance investor understanding of target-date funds and we fully support the idea of requiring clarification in the disclosure provided to target date fund investors. We recently testified at the joint Department of Labor/Securities and Exchange Commission hearing about target date funds and proposed five disclosure principles to enhance investor understanding of these investment vehicles. Link here to read more about the disclosure principles and our testimony: irement/09_news_target_fund

For more information on target date funds, I encourage your readers to check out these FAQs:

Thanks for the opportunity to comment – Ianthe Zabel, Investment Company Institute, Senior Director, Media Relations

You might be interested in reading John Rekenthaler’s M* response to your post at blogentry.asp?id=16767&email=pb0702A3. My response to John appears below. I would only add to my M* response, in further response to the ICI, that the issue is not about disclosure. It’s about a fund naming itself “2010 Fund” and then investing 70% to 80% of its assets in equities. The solution is not to hold investors who are looking for a one-stop solution responsible for reading the fine print in the prospectus. I challenge the ICI to utter the words: “There is nothing misleading about a ’2010 Fund’ investing 75% of its assets in equities.” Go ahead. Make my day.

Mercer Bullard

The following is my response to Rekenthaler’s critique of Salmon’s post:


I am usually cheering after reading your analysis, but this time I have to disagree. Investors did not experience the average performance of 2010 funds. They experienced the performance of the 2010 fund in which they invested, and some of those funds had 70% to 80% of their assets in equities. I think that you would agree that this is a very aggressive allocation for someone retiring next year, especially for a fund that specifically labels itself as a “2010″ fund. You’re absolutely right that the date 2010 refers to the date of retirement, and that is precisely why it is misleading for a so-named 2010 fund to take such an aggressive equity position. Investors looking for a one-stop fund are most likely to rely on the allocation that is implied by the name, and the implied allocation is decidedly not 70-80% equity for a 2010 fund. The name is inherently misleading. Salmon is correct that fund managers have incentives to overweight equities because of the higher profit margins that equity funds typically earn. They also have incentives to overweight equities because after strong equity performance an equity overweighting will have generated higher returns and create the (misleading) appearance of superior management. As Don Philips often quips, the best way to outperform your investment category is to invest outside of your investment category. That’s precisely what they have done. My and the CFA’s comment letter on the SEC/DOL target date fund hearing provides a fuller analysis of the issue at earing6.18.09.pdf. I think that you make an excellent point, however, that we need to look at rolling performance, not just 2008 performance. The investors who lost their shirts in a 75%-equity 2010 fund in 2008 actually had experienced superior performance in prior years (assuming that they were invested then) that should be taken into account when evaluating the performance of specific funds. But they still were misled and experienced lower performance as a result. And then there are the 529 college savings plans that offered investment options for 17- and 18-year-olds with a 50% equity allocation. Now many of them won’t be going to college. But that’s another story.

Mercer Bullard
President and Founder
Fund Democracy
Associate Professor of Law
University of Mississippi School of Law