My Two Cents

Target date funds

Chris Farrell Jan 18, 2009

The Wall Street Journal on Jan. 17 has a good article on target date funds. (You need a subscription to look at many WSJ articles. Here’s the link.)

In essence, these are supposed to be one-decision buys. You invest in one fund. It allocates your money among a handful of assets–stocks bonds, cash, international equities, and the like. The portofolio grows more conservative as retirement nears. hence the term “target-date” funds.

The 2006 Pension Protection Act encourages employers to enroll new employees automatically into their retirement savings plan. A target date fund is now an acceptable default option if an employee isn’t sure where to invest among the choices offered by the employer. (Before 2006 the common default option was a money market mutual fund.)

Zvi Bodie, finance professor at Boston University, argued against using target date funds as the default option. He said it was to risky a strategy. He proposed that if target date funds were so great then the mutual fund company should make up any shortfall at retirement time. As you imagine that idea went nowhere.

Too bad. According to the Wall Street Journal, most target funds with a retirement date of 2010 were still heavily invested in equities. “Most of these lost at least 20% — and some more than a third — last year. That’s better than an all-stock portfolio would have fared, but losing a big chunk of your balance a year before your anticipated retirement can obviously derail those plans.”

Bodies and other critics were right. Bodie argues that the default option should be TIPS–Treasury Inflation Protected Securities? That way the savings will be there, adjusted for inflation. There is no credit risk.

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