Look Inside the Target Date Retirement Funds in Your 401(k)

If you have a 401(k) plan or similar, then you most likely have a target-date mutual fund (TDF) as the default option. This is a direct result of the Pension Protection Act of 2006 (PPA). These funds contain some mix of stocks and bonds, and the asset allocation changes according to a “glide path” as you reach your “target date” of retirement, and were designed as a stupid-proof, low-maintenance option for investors. But did this turn out to be a good thing or a bad thing?

The Freakonomics blog notes a new academic paper Heterogeneity in Target-Date Funds and the Pension Protection Act of 2006 [pdf] by Balduzzi and Reuter. Heterogeneity is just a fancy word for they tend to be very different from each other even though the yearly dating system can make them seem similar. For example, the WashingtonRock 2020 Fund could be completely different than the LincolnStone 2020 Fund. Why? Their theory is that because every 401(k) now would have a target date fund inside, then every fund provider would have to create a target date fund. However, you wouldn’t want your TDF to be the same as the other guys’ TDF, so you’d make yours slightly different, right?

Here is a glide path comparison done by State Farm showing the paths of the major providers Fidelity, Vanguard, and T. Rowe Price:

(click to enlarge)

My personal theory is that if they did end up nearly the same, then you’d start comparing performance and it would be very easy to see that the resulting small differences in performance were directly due to costs, or expense ratios. If that were the case, Vanguard would win almost every time. But if you added more stocks or less stocks, or threw in some commodities or something, then you could at least have a chance of outperformance. In any case, all this “Look, I’m special” business made the real-world performance of TDFs – even those with the same target date – highly variable:

Consider the 68 TDFs with target dates of 2015 or 2020 in 2009. The average annual return was 25.1%, the cross-sectional standard deviation was 4.4%, and the range (the difference between the maximum and minimum return) was 23.5%. Some investors earned an annual return of 35.4% while other investors, investing in a TDF with the same target date, only earned 12.0%. […] Turning to asset allocations, the average allocation to bonds and cash was 35.3%, with a standard deviation of 16.2%, and a range of 104.4%. Our findings demonstrate that TDFs with similar target dates can follow significantly different investment strategies. If regulators assumed that TDFs with the same target date provide investors with similar exposure to risk, the assumption is questionable.

So while you were supposed to be 5-10 years from retirement, your money could have earned 12% or 35%. Even within a standard deviation, your fund could have held between 49% stocks to 81% stocks (51% bonds/cash to 19% bonds/cash). That’s a huge difference.

Don’t pay attention to the “Target Date” of your fund. It means nothing! Use a tool like Morningstar X-Ray to find out how much your fund is holding in stocks vs. bonds, and also find out how much you’re paying for your ETF every year by noting the expense ratio. You might do better with individual funds, and owning two or three funds instead of one isn’t quite rocket science. Ibbotson Associates also has a paper on Glide Path Instability [pdf] that outlines the glide path of several smaller providers.