Despite High Participation in Target-Date Funds, Uncertainty Looms Large

(August 1, 2011) – Although participation in target-date funds is increasing, satisfaction with the retirement-centric funds is unexpectedly low, research from Dimensional Fund Advisors’ DC Dimensions magazine revealed.

The funds, whose asset allocations become more conservative as retirement approaches, are common defined contribution vehicles for retirement accounts like 401(k) plans. According to Dimensional’s research, only 22% of participants say that they are “very satisfied” with their investment. 57% of participants reported being “somewhat satisfied,” while the remaining participants were dissatisfied with their investment.

The research was based on interviews with 1,000 participants in target-fund plans. Of the 78% of participants who were not “very satisfied” with their investment, 49% reported that their satisfaction was sub-optimal because of target-date funds’ poor returns relative to other investment options.

In spite of low satisfaction, participation in target-date funds is the highest since the crisis. Research from Ibbotson Associates shows that inflows into target-date funds during the first quarter of 2011 exceeded $16.5 billion, the highest total since before the crisis. The second quarter of 2011 saw $10.8 billion in inflows, marking a 10.7% increase from the same quarter last year. These increases in participation occurred in spite of modest returns during both quarters for the funds: in the first quarter, the average target-date fund had a 4% return, 1.9% lower than the S&P. In the second quarter, the average fund had a return of 0.6%.

Despite positive participation numbers, industry experts agree that there is reason for concern over target-date funds. aiCIO sister publication PlanSponsor recently published an article entitled “Target-Date/Risk-Based Fund Guide: Missing the Target.” The article explains that the lack of a clear benchmark for target-date funds makes classifying and comparing the funds very difficult. As a result, “It is very hard to pick the right fund, and to know afterward if you picked the right fund,” according to Pamela Hess, the director of retirement research at Hewitt Associates LLC. Other difficulties include the importance of risk/reward tradeoffs along with overall return as well as the fact that the funds are all relatively new.

In a press release from Folio Investing, Folio founder Steven Wallman said that he believes that target-date funds have still not distanced themselves sufficiently from the high exposure to stocks and bonds that led to the funds’ large losses during the crisis. “Most Target Date Funds apply an approach to asset allocation that can be enhanced…Our analysis shows that [target-date] funds are not as well diversified as they could be beyond stocks and bonds — which are correlated with those stocks — thereby leading to a high exposure to risk from a decline in stocks,” Wallman said.

Morningstar’s 2011 Target-Date Industry Survey reports that the “much-maligned” funds have almost fully recovered their losses from the crisis. In spite of this, Wallman says, the funds’ portfolios need to focus on what he calls “true diversification”: a broad range of asset classes and an investment strategy that aims for uncorrelated or negatively correlated assets.