Mixing Target Date Funds May Harm Portfolio

By Gregg D. Killoren, J.D., CCH State Banking Law Reporter, Bank Digest and Individual Retirement Plans Guide, Jan. 26, 2010.

Plan participants who invest in target date funds along with other funds could end up with a potentially inferior portfolio in terms of risk/return tradeoff, according to a study published by the Employee Benefit Research Institute (EBRI).

Target date funds, a rapidly growing option in 401(k) retirement plans, are designed to simplify long-term investing by automatically adjusting to more conservative investments as the fund approaches a set date. Because target-date funds were designed to be “all-in-one” portfolios that diversify asset allocations and rebalance over time based on a defined target-date horizon, participants who lack financial literacy or desire to use institutional expertise in asset allocation and portfolio rebalancing may benefit from investing in these funds, the study notes.

The EBRI study found that, at year-end 2008, nearly 7 percent of 401(k) assets were invested in target-date funds. The study used a sample from the 2008 EBRI/ICI 401(k) database looking at plans having at least 10 participants and offering any target-date funds (TDFs) in 2008. The sample included participants between ages 20-69 with an account balance of between $10,000 and $250,000 as of year-end 2008. Among participants in their 20s, 15 percent of their assets were invested in TDFs, while among participants in their 60s, almost 6 percent of their 401(k) assets were invested in the funds. This is the result of recent legislative and regulatory inducements, notably the Labor Department’s approval of TDFs as a qualified default investment alternative in 401(k) retirement savings plans, according to the study.

Emergence of “Mixed” Target Date Fund Investors

The study notes that as TDFs are offered to plan participants (either on a default or voluntary basis), a new class of investors is emerging: TDF users who hold the funds in combination with other funds in their 401(k) plan menu. TDF users holding other funds, referred to as “mixed” TDF investors, are likely to be middle-income and middle-wealth participants. Mixed TDF users accounted for about 55 percent of the participants holding TDFs in their accounts as of the end of the year 2007. Those investing only in TDFs are referred to as “pure” TDF investors. They are more likely to be younger or lower-salary participants who are automatically enrolled into TDFs.

Overall, the study says, some mixed target date fund investors “apparently fail to understand” that a TDF is designed as an “all-in-one” portfolio solution. Thus, “holding TDFs with other funds could lead to an unexpected result of ending up with a potentially inferior portfolio in terms of risk/return tradeoff from more assets allocated to some sectors than the designers of the target date funds had planned,” the EBRI study concluded. For instance, the study found that mixed TDF users are more likely to hold multiple TDFs than are pure users who invest only in TDFs, and “low-level” mixed TDF users (who invest less than half of their account balances in the funds) are more likely to use two or more TDFs than are “high-level” mixed users (who invest more than half their balance in the funds).

In addition, mixed users holding relatively aggressive TDFs for their age group (such as someone in their 50s investing in 2050 funds) are more likely to actively invest in equity funds than those following the age-specific investment rule, the study found.