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New Problems With 401(k) Target-Date Funds

It turns out that target-date funds don’t solve a common 401(k) problem: taking the money out too soon.

Investors learned the hard way in 2008 that target-date funds don’t necessarily protect them when the market crashes – not even funds that are marketed to people close to retirement age. Now it turns out these products also don’t solve another common 401(k) problem: taking the money out too soon.

Target-date funds are funds of funds that automatically adjust their asset allocation to track the investor’s age and declared retirement date. Supposedly, they ensure that unsophisticated participants follow a sensible asset allocation that will make their money last.

Thus, older 401(k) participants assumed that a “2010” fund – aimed at sixty-somethings who planned to retire around that year – would be conservatively invested almost entirely in bonds. Boy, were they shocked when they found that these funds were typically half in stocks and fell an average of 24.6 percent in 2008, according to Morningstar. (Some funds with later due dates also underperformed the markets but weren’t as much of a shocker because they were expected to be more in equities.)

Back then, the managers argued that these funds need to maintain an equity exposure well beyond retirement, because people are living decades longer. Their so-called glide paths, or asset allocation schedules, often go on 10, 15, even 30 years past the supposed retirement date, gradually adjusting the mix more and more away from stocks. Nevertheless, under a hail of criticism, some fund companies reined in their asset allocations or added some options to hedge the rest of the portfolio.

Whether aggressive or conservative, the controversy over glide paths highlights another problem. According to Aon Hewitt, 31 percent of participants cash out their 401(k) holdings at age 65. Another 31 percent roll their accumulation over to another savings vehicle like an individual retirement account, with the remainder keeping their money in the plan. “They see this big lump of money, and most of them want to take it,” says Robyn Credico, a senior retirement consultant at Towers Watson. The worry is that if they spend it too quickly, there won’t be enough to last their lifetimes.

But certainly investors in target-date funds won’t be prone to this mistake, right? They have their 30-year glide paths to remind them. Moreover, they’ve chosen these funds precisely because they don’t want to do a lot of financial decision-making. Even more passive are the employees who were automatically enrolled in 401(k) plans by their companies and then automatically put into target-date funds as the default investment option, because they never took the step of signing up.

Well, guess again. When J.P. Morgan Asset Management analyzed the 200 plans it administers, covering the years 2006 through 2008, it found that fully 80 percent of the participants who were automatically enrolled in target-date funds had pulled out all their money within three years of retirement, with only about half of them rolling over the assets into an IRA. That’s a lot worse than the overall 401(k) numbers from Hewitt.

Anne Lester, head of target date strategies at the asset management group, says she can’t explain why these investors yanked their money out – beyond the usual explanations – because J.P. Morgan just looked at the data without surveying the employees. But she rules out any connection to the current financial crisis, because “we saw very similar patterns of behavior in 2006 and 2007.”

So if even target-date funds don’t work, what will?

Credico of Towers Watson offers the old chestnut – education. “You have to communicate to people that this is a fund designed to keep you all the way through retirement,” she says.

But Lester says that if people aren’t saving enough to last their lifetimes, it’s part of a much bigger problem that goes beyond target-date funds, involving behavioral psychology and lack of personalized investment advice within plans. “It’s hard for me to figure out how defined contribution plans become more certain,” she says, “as long as individuals choose how they save, how they invest, and how they pull money out.”

In other words, don’t count on DC plans for the retirement security you used to get with a pension.

Fran Hawthorne is the author of the award-winning “Pension Dumping: The Reasons, the Wreckage, the Stakes for Wall Street” (Bloomberg Press) and “Inside the FDA: The Business and Politics behind the Drugs We Take and the Food We Eat” (John Wiley & Sons). She writes regularly about finance, health care, and business ethics.

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