Target date funds are working but they can be expensive

Funds are throwing off solid returns and protecting investors from their worst instincts

Apr 25, 2015 @ 7:00 am

By Bloomberg News

For a decade, a new kind of mutual fund has been taking over Americans' retirement portfolios.

The target-date fund is designed for people with no knowledge of investing. You pick the fund closest to the year you expect to retire — the Vanguard Target Retirement 2030, for example — and the fund does the rest. Containing a variety of stock and bond funds, the all-in-one funds gradually and automatically get less risky as retirement approaches.

There's now evidence that target-date funds may be working. They're giving investors solid returns, data from research firm Morningstar Inc. show. Just as importantly, they're boosting those returns by protecting investors from their worst instincts.

(More: Few target date fund managers eat their own cooking)

Good thing, because the retirements of millions of Americans, and especially young people, now rely on target-date funds.

This year, for the first time, more than half of all 401(k) contributions will go into target-date funds, research firm Cerulli Associates estimates. It projects the assets in target-date funds to hit $2 trillion by 2019, when 88% of all 401(k) contributions will go into the funds.

With 10 years of history, there's now enough of a track record to judge just how well investors are doing in target-date funds. The average per-year return over the past decade was 5%, Morningstar estimates. That's about what you would expect from funds that are a blend of stock and bond funds. Stock funds were up an annual 7.5% over the past decade, while bond funds were up an average 4.4%.

BIG ADVANTAGE

But target-date funds have one big advantage over other kinds of mutual funds, the data show. The average mutual fund has a flaw, which is that the average investor hardly ever does as well as his or her funds. Investors tend to jump in and out of funds at the wrong time. They buy high, choosing funds only after they've done well. And they sell low, dumping underperforming funds just as they're about to take off.

Picture an investor buying into a tech fund at the height of the Internet bubble in 2000 and then selling a few years later just before the sector revived along with such stocks as Google and Apple.

Investors in target-date funds, at least so far, seem to have avoided this curse. They've been sticking with their funds and doing surprisingly well in the process.

On average, target-date fund investors are doing 1.1% better per year than their funds. Investors in almost every other fund category lagged their funds over the past decade, including a -0.98% underperformance for U.S. equity funds and -1.3% for municipal bond funds.

VINDICATION?

Does this vindicate target-date funds? Not so fast. It's possible the performance of target-date investors is a historical accident, caused by the funds' growing popularity during a six-year bull market for stocks. The next time markets hit 2008-style turbulence, these investors may bail out of target-date funds, selling at the wrong time just as they panicked over their stock funds six years ago.

(More: Fund expense ratios continue to fall as fund companies get richer)

Another worry about target-date funds is their fees. Target-date funds charged investors 0.78% in fees last year, Morningstar says. That's down from an expense ratio of 1.04% in 2008. But it's still a drag on performance, with some investors paying three or four times more than others. Vanguard's target-date funds charge 0.17% per year, and new funds from State Street and Pacific Investment Management Co. (Pimco) charge less than 0.3%. But meanwhile, more than a dozen target-date fund series still charge 1% or more.

Target-date funds may prove to be a valuable tool, but only at a reasonable price.

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