Monday, October 24, 2011

Why I LOVE to HATE Target-Date Funds

A survey, by the Plan Sponsor Council of America, found that while equities amount to 63% of 401(k) plan assets (yea!), the most popular investment option utilized in 401(k) plans is actively-managed equity funds (boo!).

The survey also found  target-date fund popularity grew from less than 3% of 401(k) plan assets in 2006 to 13% in 2010.  In that same time frame, the percentage of plans that offer target-date funds rose from 33% to 63%.  Casey Quirk & Associates project that almost 50% of 401(k) plan assets will reside in target-date funds within 10 years.

I have a LOVE / HATE relationship with target-date funds.

I love the concept of “target-date” mutual funds.  The idea is an employee with a 401(k) only needs to know their approximate retirement date and then put all their retirement money into one fund.  Target date funds are designed to hold a mixture of stocks and bonds that systematically reduces the volatility or market risk of the fund by slowly increasing the allocation towards bonds and reducing stocks over time. 

Owning a mixture of stocks and bonds that slowly shifts towards more bonds and less stocks over time with annual rebalancing is exactly what I recommend folks do in all my books.  Target-date funds do all this for you and simplifies your life.  This is an awesome idea that makes retirement planning a no-brainer, right? So, what’s my problem?

Below are the stock / bond allocations for two target date funds managed by two very well known mutual fund firms lead by famous Chief Investment Officers. 

Question:  Which fund has a target retirement date of 2030?

Ticker Symbol
% Stocks
% Bonds
% Other

Answer: Both!

So there you have a problem – target-date retirement fund allocations vary significantly from fund family to fund family.  Two people of the same age, with different employers, could have extremely different asset allocations even if both are invested in target retirement mutual funds with an estimated retirement date of 2030.

Which fund above do you suppose is managed by a mutual fund company run by a very famous bond fund manager, and which is managed by a mutual fund company run by a very famous stock fund manger?

The fund with the biggest allocation to bonds is run by a firm with a very famous bond fund manger and the fund with the largest allocation to stocks is run by a very famous stock fund manager. 

PRLIX is the ticker symbol for the PIMCO RealRetirement 2030 Fund and PIMCO’s Chief Investment Officer is Bill Gross – perhaps the most famous bond fund manager on the planet.

LMVIX is the symbol for the Legg Mason Target Retirement 2030 Fund and the Chief Investment Officer for Legg Mason is Bill Miller – one of the most famous stock fund managers on the planet.

There is a saying, “if all you have is a hammer, everything starts to look like a nail.”  This could be the problem with these two funds, as PIMCO, the famous bond fund company clearly favors bonds while Legg Mason, the famous stock fund company clearly favors stocks.

I’d actually recommend an allocation of 60% stocks and 40% bonds for the “typical” person retiring around 2030.  Thus, my opinion is the Legg Mason fund above is too aggressive and the PIMCO fund is far too conservative for the “typical” person retiring in 2030. 

This brings us to another problem: What is “typical?”

I would argue that there are very few “typical” people and the one-size fits all target retirement date mutual funds may not be appropriate for many investors.  Two people that are both looking forward to retiring in 2030 could be VERY different people. 

First, they could be very different in age if one is planning to retire “early” at say 55 years of age, while the other may be planning to work until 75.  The older person, all other things being equal, should probably have a more conservative portfolio.

Second, even if two people are the same age and plan to retire the same year, they could have VERY different health.  Someone in perfect health might need a more aggressive portfolio than someone who is in poor health - perhaps suffering with cancer or diabetes or some other health problem.

Third, two people could be of same age and health, but one has $50,000 saved and the other might have $1.5 million saved.  I would argue the wealthier person can afford to be more aggressive with their portfolio even late in life.

Fourth, consider two people the same age, health, and both have saved $500,000 for retirement.  One could be single while the other is married with 4 kids in college.  Fifth, perhaps one will receive a pension of $40,000 per year while the other has no pension.  Sixth, maybe one lives in San Francisco and pays $6,000 a month in rent while the other lives in San Antonio and lives in a house with no mortgage?

Even if you could come up with two people that are identical in EVERY economic way possible, they could be VERY different emotionally.  Smooth Sally might be very laid back and calmly reviews her 401(k) statement once per quarter, while Nervous Nick watches too much CNBC and checks the value of his 401(k) twice before lunch every day.  Nervous Nick should be in a much more conservative portfolio than Legg Mason would likely put him in, while PIMCO might put Smooth Sally into a portfolio that is far too tame.

Imagine a 21 year old man who shows up for his first day of being a waiter at Denny’s.  His boss hands him the “typical” employee uniform – a size 10 dress.
My point is there are no “typical” people.  Target date retirement funds only take into account one of dozens of potential variables that make EVERY investor different.  This is why I love the idea of a simple one-size fits all mutual fund, but in reality, one size does NOT fit all. 

This is also why I include a questionnaire at the beginning of all of my books that attempts to give each reader an investment recipe that is seasoned specifically and not typically.


  1. That's a meaningful discussion Ron -- cogent, lucid and rational. Now let me throw you a curve: I've never owned a bond and I never intend to own one. (I'm just talking bout me. I've purchased plenty of bonds for clients.) When I tell people this the response is always the same, “Bonds reduce volatility.” To which I reply “That’s your argument? That’s the best you can do?” There's no money to be made in bonds -- in the long run.

  2. Excellent point Steve. That is why one of my favorite books is Jeremy Siegle's "Stocks for the Long Run." I agree that stocks will beat bonds over the long-run. I've always said the only reason to own bonds is to keep you from selling everything during a stock market downturn. Plus, bonds can beat stocks for periods as long as 10 years (for example the last 10 years). That is why annual rebalancing is so vital to portfolio performance. Folks can do quite well owning a mix of both stocks and bonds and rebalance each year. In effect, you buy low and sell high over and over year after year. So, a few bonds can smooth the ride and not give up too much in performance once you factor in the performance gains from rebalancing. You are a professional investor and can understand the volatility of stocks without wetting your pants when 2008 or 2000-2002 happens again. Most non-finance geeks need a smoother ride than you and I.

    From a theoretical perspective. The text books say you can own an "optimal" portfolio (one that maximizes return for given unit of volatility) and lever it up. You can theoretically create a portfolio with the same return as your 100% stock portfolio but with lower risk (or get the same volatility and a higher return). Of course you've got to be able to borrow cheaply...