The Shortcomings of Target Date Funds

Rachel Haig: I'm Rachel Haig for Morningstar.com. Target Date Funds can be a
really easy way to diversify your portfolio and access professional
management at a relatively low cost. However, there are important
considerations when you're deciding whether to invest in a target
date fund.

Here with me today to discuss those and how you know if you
should avoid your target date fund is Morningstar's director of
personal finance, Christine Benz. Thanks for joining me Christine.

Christine Benz: Rachel, great to be here.

Rachel Haig: So, target date funds are supposed to be a one-shot diversification,
but not all of them access different areas of the market in the same
way. How do you know if your target date fund is a good way to
diversify or if it has some shortcomings?

Christine Benz: Well, most of them will have some shortcomings so not all of these
funds or most of these funds, do not cover all the major asset
classes. So it's very common to see that target date fund that has no
explicit inflation protection, for example, no TIPS fund, no
commodities, no nothing. In that case, that's not a deal-breaker, in
my view. You can easily augment the target-date fund with an IRA
that includes commodities or TIPS. So I wouldn't get too
concerned if I saw a short fall in a category like that.

What you want to be on the lookout for is that you're essentially
putting all your eggs in one basket, so the firm needs to be decent
at least at all of the major asset classes. So, for example, if you
look at some of the underlying fixed-income holdings and see that
this is a shop that really doesn't do fixed-income well, that's a
concern, and that will be an increasing concern as you hold the
target-date fund and it includes more and more fixed income.

So you want to try to get a sense of how the firm does at managing
within domestic equity, international equity and fixed income.
Make sure at least it has some baseline competency within those
areas before you invest a lot of money in a target-date fund.

Rachel Haig: What about expense ratios? I know they vary a lot especially in
target-date funds. There are some as low as just 0.2% and they go
all the way up to about 1.8%. How much is too much in terms of
cost?

Christine Benz: It's a great question and you're right, there is a broad disparity. And
some of these funds are bundling in administrative costs for putting
the whole thing together or for administering the plan. So you will
see a broad range. I think for simplicity sake, it helps to set the bar
at about 1% all in costs for a target date fund. If you see expenses
higher than that that's a pretty big red flag that you've got a costly
plan and just for comparison sake, Fidelity which has some of the
largest funds, prices its target date funds kind of at the realm of 55
basis points up to 75 basis points. So that's just kind of a ballpark
view of where some of the bigger funds are priced currently. If
you're much higher than that, that's a red flag.

Rachel Haig: Looking at the underlying funds that the target date series invest in,
are there any red flags there that you should watch out for?

Christine Benz: Well, one thing that we've seen and I'm happy to say that we're
seeing less of this, but when target-date funds were initially
launched, what we saw is that sometimes fund companies were
stuffing in funds that weren't particularly attractive in their own
right. Maybe they were looking to gather assets in those funds, but
they weren't necessarily the firm's best offerings.

So, when you look across the holdings of a target-date fund and
that's an important part of the analysis. You want to make sure that
the holdings are indeed representative of the best of what the firm
has to offer. It shouldn't be a basket of also-rans.

You also want to be on the lookout for overly defused portfolios,
so do they have too many holdings and maybe that's watering
down the contributions of the really good funds. That's something
that we've seen and that's been a criticism of our analysts in terms
of Fidelity's Freedom lineup, for example.

We think that they're certainly serviceable, low cost, target date
funds, but we would like to see them do a little pruning and put
more of the assets in Fidelity's high-conviction names.

Rachel Haig: Well thanks for helping us identify the target-date losers.

Christine Benz: Thanks, Rachel.

Rachel Haig: For Morningstar.com, I'm Rachel Haig.