A new white paper released by The Compass Institute LLC, a Chicago-based think tank, indicates that target date funds aren't as adequate as other ways of helping employees save for retirement.
According to the research, which was conducted over a 10-year period, life cycle funds such as target date funds yield far lower returns than other investment methods.
Investors who start in an up market can expect an annual average return of 8.8% if they are in the best-performing life cycle fund and 6.9% in the worst-performing life cycle fund, compared with 16.2% using an adaptive asset allocation strategy, the paper showed.
Investors who start in a down market can expect an annual average return of 4% in the best-performing life cycle fund and 2.9% in the worst-performing fund, compared with 11.9% using adaptive allocation.
"We feel very strongly that target date is just the worst possible thing," said Elliot N. Fineman, senior vice president of the Compass Institute, who also crafted the report.
The report compared a formulaic asset strategy — which is commonly used in life cycle, target date and balanced funds — with an adaptive asset allocation strategy.
The report showed that participants would do better with the latter, which is a risk management strategy in which the portfolio is re-balanced every five weeks.
In each five-week period, participants are invested in the best-positioned funds available on the 401(k) menu.
The study comprised data ranging from 1997 to the present, and reviewed about 500 plans.
Target date funds have faced scrutiny because they are considered one of the top options as the qualified default investment alternative in 401(k) plans that choose to enroll employees automatically.
As of Sept. 30, assets in target date funds totaled nearly $168 billion, up from $98 billion a year earlier, according to Financial Research Corp. in Boston.
The Compass Institute's white paper showed that putting participants in life cycle funds such as target date funds exposes investors to the higher risks over market cycles and "assures their not -having nearly enough money in retirement."
The reason these funds don't work in the long run is because in a down market, it' is difficult for them to recover, Mr. Fineman said.
"When the market recovers, they always have 20% to 30% lost money that they can't recover," he said.
Industry leaders think that the concept of target date funds is important but worry that investors may not get the best returns if they've been placed in a fund that has a different strategy than expected.
While these funds aren't perfect, they are far better than letting participants hand-pick their own investments, said Gary Terpening, a product manager with Seligman Advisors Inc., an affiliate of New York-based J. & W. Seligman & Co. Inc. "One thing I constantly hear from financial advisers and plan sponsors is that almost any type of target date strategy will be superior to leaving someone on their own," he said.
It's likely that industry leaders will continue to debate the assets that target date funds should comprise, Mr. Terpening said. He maintains that the glide path of the target date fund should be weighted heavily toward equities over a long time period.
"Without question, one of the biggest issues right now within the fund industry is: How do you evaluate, benchmark and design these funds?" Mr. Terpening said.
What's important to remember is that target date funds are still a relatively new asset class, and it is likely that fund companies will continue to tweak their strategies, he said.
Regardless of the flaws in target date funds, Chris Lyon, a partner at Rocaton Investment Advisors LLC in Norwalk, Conn., said he still recommends these funds to most plan sponsors.
"This isn't a perfect solution, but it's a pretty practical reasonable solution," he said. "We're very supportive of the entire concept of target date funds."
Mr. Lyon also believes that what's critical about these funds is how they develop in the long term. He thinks that they will continue to evolve.
"I think most of the major managers' funds will look different in their composition than they do today," Mr. Lyon said.
"They'll include innovative products. A target retirement fund that doesn't evolve must be either really good today, or in 10 years, it'll be pretty lame."
Lisa Shidler can be reached at email@example.com.