Reuters Money

Target date funds (TDFs) have taken off in recent years as more workplace retirement plans install automation options.

TDFs invest in a mix of assets and aim to reduce equity exposure as participants approach retirement. The basic idea is good, considering that many investor portfolios suffer from benign neglect when it comes to rebalancing, fund selection and reducing exposure to riskier investments as retirement approaches.

But many retirement investors don’t really understand how TDFs are allocated between equities and fixed income. Fees can be high, and some critics don’t think TDFs are structured to select the best-in-class funds for all asset groups.

If you’ve defaulted into a TDF, check under the hood for these common problems:

Misunderstandings about risk: TDFs have come under fire for maintaining high equity allocations even in funds tailored for investors near retirement age. Many TDF investors near retirement age suffered dramatic losses in the 2008 market crash. Target funds with dates between 2000 and 2010 lost 22.5 percent in 2008, and funds with target dates between 2011 and 2015 lost 28 percent, according to Morningstar. But those are broad averages; some funds with dates as early as 2010 lost as much as 50 percent of their value in 2008.

The big 2008 losses can be discounted — to an extent — by the once-in-a-lifetime nature (one hopes) of the financial crash; the resulting liquidity crisis forced many fund managers to sell whatever they could to meet redemptions, resulting in especially large losses even in well balanced TDFs. But that doesn’t change the fact that there’s no industry standard for fund naming, or the perception gap among near-retirement investors who think they’ve adopted a more conservative posture.

The industry notes — correctly — that the glide path for most TDFs isn’t the target year of retirement, but some point beyond. “More TDFs are designed to deliver investment strategies for life — not just for your working life,” says a spokesman for the Investment Company Institute (ICI). “Few, if any, serious financial planners would recommend a 100 percent cash (or cash-and-bond) portfolio for a 65-year-old facing the potential of 30-plus years in retirement.

Fair enough — but that only points to the challenges of education and expectation-setting created by the way these funds are named. Disclosure and transparency also need to be improved; here’s what Morningstar had to say on the subject in its most recent annual survey of TDFs:

There are several major areas in which significant philosophical and pragmatic differences exist among the target-date series. These areas, outlined over the next five pages, are critical in fully comprehending the potential risks and performance behavior of a given target-date series and how that series compares with others in the target-date universe. Yet the disclosure and transparency on these subjects is in most instances inadequate. Even for Morningstar, it can be a struggle to get consistent information on basic glide-path allocations, never mind more sophisticated data.

Reforms have been proposed both by the Department of Labor and Securities and Exchange Commission aimed at addressing concerns about TDF naming, marketing and disclosure; the industry has endorsed some of the proposed changes.

High fees: Critics charge that fees often are too high due to the “fund of funds” construction of TDFs. Many TDFs charge fees for the underlying funds plus an overlay TDF management fee. The industry disputes this criticism; ICI notes that the asset-weighted average expense ratio for TDFs was 0.66 percent of assets as of May 2009, compared with 0.84 percent at year-end 2008 for comparable stock funds, and 0.63 percent for bond funds.

But a report from Brightscope, which measures and analyzes 401(k) fund performance, argues that asset weighting masks the true costs of most TDFs. Brightscope research indicates that the only two target date fund series with expense ratios below 0.66 percent are those of Vanguard, with a rock-bottom 0.19 percent and USAA (0.64). “The rest of the funds have fees over 0.66 percent,” Brightscope reports, “and over 50 percent of series have fees that are one percent or higher.”

“The more data you look at, you see that target date funds are a clever way to ratchet up fees in comparison with just selecting three or four individual funds,” says Mike Alfred, Brightscope’s CEO.

Home cooking: TDFs usually are assembled from in-house, proprietary underlying funds run by the record-keeping companies hired by plan sponsors. The problem: no one company will have best-in-class funds in every asset class. “One company might excel at large cap funds,” says Adam Bold, CEO of The Mutual Fund Store, a fee-only investment advisory. “But when you blend the return of all the proprietary funds in the TDF and layer on fees, it dilutes the performance down to mediocre or worse.”

If you’re in a TDF with high fees and sub-par performance, ask yourself whether it might make sense to turn off the cruise control by picking individual funds and rebalancing from time to time. Here’s what you’d need to do:

1. Set the right equity/income mix. You’ll need to decide what mix is best for now, and how much you’ll reduce equity exposure over time as retirement approaches. If you don’t have the training or experience to do so, use an advisory service like Smart401k.com.

2. Evaluate and select from available funds. For equity funds, pick the funds offering broadest market coverage with the lowest expense ratio. Advises Bold: “A fully diversified allocation should include at least one fund from each of the following asset classes: large growth, large value, small growth, small value, international, and bonds if appropriate.”

3. Ask your plan sponsor if any advisory services are provided. A growing number of plan sponsors are adding these services at no charge through their record-keeping firms. Advisers can help with fund selection and equity/fixed income balance.

4. Rebalance twice a year. It’s important to keep the equity and income parts of your portfolio split in roughly the same proportions you originally built into your plan. That means that you have to regularly rejigger your holdings so they stay in that balance.