The Problem with Target Date Funds

Yesterday’s New York Times had an article about the simmering controversy over target funds headlined Target-Date Mutual Funds May Miss Their Mark. (Get it? It’s a pun.)Toddler Cart Crop - Remi  Jouan

Target date funds have been around for a long time. They are a sub-species of asset allocation funds, mutual funds that, in effect, own other mutual funds in order to create a diversified one-stop-shop for the investor either too busy or too intimidated to pick his own. I’m not a big fan. I think you can do better making your own asset allocations, but that has little to do with the current round of hand wringing in Washington.

To understand what has caused the present consternation, you have to go back a few years.

There has always been the problem that too many workers fail to take advantage of the spiffy 401k plans offered to them. One approach to this problem is to understand it as a symptom of a larger tragedy that needs addressing, the fact that so many of us are in dire need of a better understanding of personal finance.

Another approach would be to ignore the big picture and harness the laziness and intimidation induced inertia of the American worker to get the outcome you want. Just make participating in the 401k plan the default, i.e. new employees have to fill out a form not to participate. Guess which path our government chose.

And for a while this looked like a great success for what might be called Nanny State Lite, the idea that the government can help you help yourself in a subtle way that you will hardly notice and that will maintain the pretense that we think you are an adult.

Ah, but just setting aside a part of your paycheck in a 401k isn’t enough. That money has to be invested. Traditionally, the default investment for 401ks was a money market fund, a.k.a. cash. And that made good sense. Everything else is risky and could lose money. Who wants to answer to a worker who lost some of his savings on something you picked for him, even if you meant well?

But if you are invested in cash, you can’t participate in the fabulous returns available from the stock market. So Nanny, who knows what’s best for you, changed the rules in 2006 to allow employers to set a target date fund as the default for 401ks.

You can guess the rest of the story. Everything went swimmingly until 2008, when those target date funds went down rather a lot and the kids started to resent Nanny’s help. Then Nanny, to paraphrase Casablanca, became simply shocked to discover that gambling was taking place in the target date funds.

From the Times:

Mary L. Schapiro, the chairman of the S.E.C., is now questioning whether fund companies misled investors about the risks associated with target-date funds, a concern the mutual fund industry says is unjustified.

The mutual fund industry is right. The composition of a target date fund and the risks involved is far from secret. It’s in the fund literature, on the website, and everywhere else a person who wanted to know such things might think to look. The problem being that the investors the SEC is concerned about are those lazy kids on 401k autopilot who would never look and probably wouldn’t have understood what they found if they did.

In hindsight, Nanny didn’t think this one all the way through.

Data collected by the S.E.C. shows that target-date funds vary widely in terms of their investment risks, even when they use similar target years or names. Even though federal officials put a stamp of approval on target-date funds, there are no clear standards about how they should work.

And, of course, this has always been the case. Two funds with "2025" in their names may have only their names in common, just as two "growth stock" funds may not own a single stock in common. The relatively obvious implication of this being that allowing target date funds to be designated as the default investment in a 401k is nearly an open-ended invitation to the fund manager and employer to take as much risk as they see fit. In giving a free pass to target date funds, Congress essentially made a specific exception for something that was itself undefined. Even by Congressional standards that’s inexplicable.

Nanny, needless to say, is in no hurry to take responsibility for this mess. The SEC is considering banning the use of dates in fund names. Senator Herb Kohl, Democrat of Wisconsin, has suggested standardizing the asset composition of the funds. And there is the usual hot air about fees and disclosure.

The core truth is simple. Nanny decided that taking some risk made more sense for her charges than investing in cash. And as risks taken sometimes do, it turned out badly. The final irony is that Nanny was broadly right. Details  of implementation aside, investing for retirement higher up on the risk-return curve than a money market fund was the right move and still is.

But it begs the question of whether Nanny should be making these decisions at all. Rigging the system to get the outcome we want is nice, but it is no substitute for addressing the problem that caused the undesirable outcome to begin with.

[Photo Remi Jouan]

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