When they first debuted in the mid 90's, target date mutual funds (sometimes known as "lifecycle" funds) promised to make life easier for retirement plan participants. Use a few simple on-line tools to figure out how much to set aside from each paycheck, match your planned retirement year to the corresponding fund, and notify your plan administrator. Voila! Complex retirement calculus magically reduced to a simple 1-2-3 progression. Low fees, age-appropriate asset allocation, & one-stop shopping. Finally, a seemingly sensible short-cut to navigate the complex world of retirement planning.For such a simple and promising concept, effective results continue to elude many lifecycle fund investors. Here's why: Many investors simply lack the confidence to invest fearlessly for extended periods of time in a formula-based investment product run by a computer. Despite branding themselves as simple, the inner workings of lifecycle funds remain pretty mysterious and even funds with similar target dates can frequently have huge performance differences. Since that makes it difficult to compare options, who can blame the average Joe for feeling a bit trigger happy now and then. More often than not however, it's the siren song of performance that's responsible for redirecting aim off target.
Here's a case that helps illustrates the point. During a recent discovery meeting, a friend right on the cusp of retiring disclosed that her entire 401(k) balance was invested in a single age-based lifecycle fund. So far so good. But as you might already have suspected, there was a twist. Instead of sticking with the obvious 2020 target date fund matching her retirement horizon, she inexplicably altered course and opted for the 2050 target date...a date fully 30 years beyond her much anticipated last day of work. When gently probed about the apparent disconnect, I learned that quarter after quarter the performance table in her regular employer 401(k) statements showed the 2020 target date fund was languishing at or near the bottom. Still positive returns mind you, but nevertheless a consistent laggard in relation to the others.
Despite the fact that a simple age-based strategy was a pretty reasonable approach at the outset, a steady flow of unfiltered short-term performance data overwhelmed executive brain function and ultimately past performance became the dominant criteria driving fund selection. Behavioral experts refer to the tendency to act on the most easily accessible information as the "availability heuristic". Think of it as little more than taking a mental short-cut. In this instance, the one factor that supposedly made her specific target date fund's internal investing formula valuable - age- was totally bypassed. Irrespective of the sound strategic reasons that undoubtedly drove the initial decision, it was just easier to imagine a bleak future marked by "poor" relative returns than it was to imagine a glide path towards retirement marked by decelerating risk and stable account values. Once that storyline took hold, all other facts were overlooked and the switch was made.
What also became clear in the conversation was our friend harbored a sincere but nevertheless false belief that by confining alternative investment choices to just those in the lifecycle fund category her plan offered, at least some strategic benefit would be preserved. Not so. In fact, it's a bit like reaching your arm into the medicine cabinet and grabbing any prescription whenever you believe the one you're on doesn't pack enough punch. Chances are, you're doing more harm than good. Chasing past performance but confining it to just a small group of substitutes (at least I'm not abusing street drugs) doesn't make it better. It's risky business any way you cut it.
I can recite a lot of reasons why I think automated investing is sub-optimal and why engaging with a live trained professional is something you ought to at least consider. Not that you might have thought otherwise, but I obviously have strongly biased views favoring the independent advice model. Suffice to say, on my best days I'm only a lukewarm fan of target date mutual funds. By and large they are a one-size-fits-most product, the fees are frequently excessive for the value delivered, and the underlying premise seems to be that all investors will convert to an income producing annuity immediately upon retirement. Still, I'll be the first to admit they're a big improvement over spinning the wheel of fortune and making random fund selections in a half-baked attempt to diversify. If you are one of the thousands of retirement savers socking money away exclusively in a target date fund, do yourself a huge favor; Check your statement and make sure the life cycle fund you selected is more or less calibrated to the date you intend to stop working. If it's not, chances are you are actually paying a fee to have the computer paint a big bullseye on your own foot. That's a target you probably want to avoid just before you ride off into the sunset.
Michael Reid, CFA is a Managing Director and Partner at Exchange Capital Management. Though a self-proclaimed expert marksman with the Nerf N-Strike Elite Rhino-Fire Blaster, Mr. Reid is also known for occasionally firing errant shots directly into his left big toe.