Woes of target date funds exposed

David MoonBlog

One of the more popular mutual fund classes of the past few years is the “target date fund,” a class of funds with a date attached to the name of each fund, ostensibly allowing investors to choose a fund targeted at the person’s expected date of retirement, then let the mutual fund do the rest.

The popularity of these funds is growing exponentially. A recent report by the analytics researchers at Cerulli speculates that within two years target date funds will attract 63 percent of all 401(k) contributions and makeup almost half of the 401 (k) assets.

It sounds pretty good in theory, but at their core these funds are primarily marketing vehicles designed to attract investor money. With the Fed promising higher interest rates, many investors are poised to learn the shortcoming of these funds.

Four years ago, John Bogle, founder of the Vanguard Group, warned that these target date funds invest too heavily in bonds. This happens because the asset allocation of these funds is based on back-tested models—models that are necessarily skewed by 33 years of almost continually declining interest rates.

In the early 1980s, no one knew what interest rates would do over the next 35 years. But when 14 percent CDs earn three times the inflation rate, a heavy allocation to long-term bonds for an impending retiree makes sense.

With 30-year Treasury rates at decades lows, it is a horrible time for an impending retiree to buy those long-term bonds.

Does it make sense to have the same allocation to bonds when yields are two percent as you should when bonds pay seven percent? With an asset allocation based on historical returns, that is exactly what your target date fund may be doing.

The irony is that when interest rates reached their early 1980s peak and stocks were at 16 year lows, few investors were willing to buy either long-term bonds or stocks. They were so spooked by falling stock prices and skyrocketing interest rates that their emotions prevented them from buying the assets that would best serve them during their retirement.

As an example, consider the succinctly-named John Hancock Retirement Choices at 2020 Fund. Morningstar reports that this fund recently held 71 percent of its assets in bonds and cash. The ETF that, according to Morningstar, holds 96 percent of its assets in long-term bonds.

Someone planning to retire in 2020 is likely around 61 years old and has a 40 to 50 percent chance of living to age 85. Should someone with a mean life expectancy of 24 years have most of his assets in long-term bonds with a yield of 2.4 percent? Probably not.

And do the investors in this John Hancock fund even realize that’s what they own?


David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).