The Trouble With Target-Date Funds

A typical mutual fund-of-funds for people retiring in 2010 lost about 20-25% of its value last year, depending on who's counting. The percentage of equities in those funds varied widely. Do target-date funds need more regulation? Better disclosure?

Or is the market for target-date funds not really there?

Three for the money

People nearing retirement appear to fall into three investment groups:

The well endowed. Presumably the smallest group, in retirement the well endowed plan to emulate the followers of Tiger 21, withdrawing no more than 3% per year from their capital and accumulated income. They need not alter their long-term investment programs, except to put aside enough cash to live on for three to five years. They can keep on investing significantly in equities, even a hedge fund or two. No need to make changes at retirement merely because their time horizon drops from 25 to 24 years, or from 30 to 29.

The cash-outs are the largest group. They crave predictability. If Joe the Boomer has around $375,000 in his 401(k) five years before retirement, he doesn't want to take the risk necessary to retire with maybe $600,000. He fears he might wind up with only $200,000. Joe wants to be reasonably certain he'll retire with about $400,000 so he can buy a little business, an annuity, whatever. For Joe even the most conservative target-date fund looks too risky. Five years before retirement, he probably needs to have much of his wealth in cash or near cash. And he needs to cashify the rest as retirement moves even closer.

The spend-downs intend to draw steadily on their wealth over their retirement years – dining well the day before they die, then expiring broke. Retirement planners and most target-date funds seem to, well, target this group. But what if the target is illusory? Are spend-downs really so numerous? Is the group as large as it was a few years ago, when investing was less worrisome? And who says they need a special investment strategy? Why can't they follow much the same course as the well endowed, except for spending 4% or 5% each year?

Mind over money

A further complication: These three groups cannot be identified or ranked by net worth alone. Wanda may retire with only $500,000, but she may choose to treat it as her lifetime endowment. Wally, with $4 million. may insist he can't possibly live on less than $200,000 per annum.

Tentative conclusion: The situations and attitudes of people nearing retirement are too nuanced, too varied, to be served by prepackaged investment programs.

If so, that's bad news for vendors of target-date funds.

On the other hand, it could be good news for individuals and firms offering custom-tailored investment advice.