How good are “401k Target Retirement Funds”?

Target Retirement Funds are popular retirement vehicles used by a good majority of the working class. They make regular pre-tax monthly contribution to a work related retirement savings plan like 401k or IRA. Their employer(s) too contribute to the same savings plan – aka defined contribution pension account.

These target retirement funds are conveniently pre-packaged to match the retirement year(s) of those employed, making it easier for people to subscribe to them. Lets say there is a Target Retirement Fund 2040 – if someone plans to retire in 2040, they may choose this fund in their 401k account. Monthly contributions by both employee & employer grow in this target retirement fund until they retire in 2040. Amount accumulated in such account may be withdrawn when one reaches 59.5 years of age.

True to their label?
While the above strategy saves time & effort, data shows such target retirement funds yield sub-optimal returns both in the short and long term. The reasons are primarily two-fold:
(i) Typical allocation of these funds is in 4 categories – US Equity, Emerging Markets Equity, Property/REITs in US & Debt/Treasury funds. While the allocation looks balanced, there are hidden headwinds here that dampen returns.

For example, while emerging markets may make headline news about huge returns, due to the appreciation of USD (vs) EM currencies, net dollar returns might still be dismal. Similarly, returns from property & bond funds could pull down the portfolio returns when compared to average equity market returns.

Besides, some of these funds are designed to invest in other funds and so their performance solely depends on the performance of such embedded funds.

(ii) Secondly, these funds follow an automatic “re-balancing” strategy – which annually shifts a pre-determined proportion of money held in equity to debt as one approaches retirement. Such robotic re-balancing fails to fully take into account the individual’s risk propensity, investment in assets other than 401k and the actual retirement income needs during the withdrawal phase.

What should you do?
It is important to evaluate all the funds available in one’s 401k/IRA and choose the right funds early on. Doing this could help make a big difference in returns (minimum 2x excess returns) even over an investment horizon of 10 years!