A new issue brief from the Center for Retirement Research (CRR) at Boston College takes a “look under the hood” of the target-date fund (TDF) market, finding in broad terms that TDFs remain one of the most sensible investing approaches for plan sponsors to offer to their participants.  

The benefits of TDFs are well-known, CRR researchers argue. The funds help otherwise novice individual investors to access specialized assets in a way that rationally complements conventional stocks and bonds, and, for this benefit, TDF fees are only modestly higher than if an investor assembled a similar portfolio on his own. Beyond this, CRR finds that TDF investment returns are “broadly in line with other mutual funds” net of fees.

However, the analysis contends that plan sponsors absolutely must pick their managers carefully and make a real effort to control costs—and they must make sure their overall investing convictions match those of the manager. TDF manager decisions on market timing and fund additions do not always end up helping performance or matching the preferred investing style of a given investor in their fund, CRR observes.

“At the broadest level, each TDF has a glide path that specifies the percentage in equities and bonds over time,” the research lays out. “The bulk of the sample funds with a target date of 2035 held 70% to 85% in equities in 2011. But a quarter of the funds held equity shares either above or below this range … Interestingly, looking under the hood shows that most TDFs are not the simple mix of equities and bonds that many envision.”

CRR finds that the “typical TDF” invests in 17 funds on average. “These holdings include emerging markets, real estate and commodities,” the analysis says. “And the prevalence of these specialized assets has increased over time.”

Findings about fees in the research are particularly telling. As CRR explains, TDFs generally have two layers of fees, which include the fees charged by the underlying mutual funds and the fees added on by the TDF for the cost of managing the fund. The former are generally termed “underlying fees” and the latter, “overlay fees.”

“Like other mutual funds, TDFs often have several share classes of the same fund,” CRR finds. “Fund managers use share classes to offer different fees and services to different investors. For example, Class A shares have an upfront load fee for investments—a commission charge—while Class C shares have a level load each year. No-load shares have no commission charge but may have other fees to cover specific investment services … In addition, funds often offer special low-fee share classes only to larger investors, giving them a volume discount.”

NEXT: The fee story gets complicated 

All of these options can work, but it is up to plan sponsors and their supporting advisers and consultants to select the proper approach for their participants’ unique preferences and needs.

CRR admits the “fee story for TDFs gets a little complicated.”

“As expected, the amount of the overlay fee added by each TDF differs by share class, but the fees charged by the underlying funds are actually the same because the underlying funds all invest in the same share classes,” CRR says. “For example, despite their different names, a Class A TDF and a Class C TDF both invest in the same class of underlying mutual funds.”

The research notes that some investors, hearing this, may prefer attempting to replicate a TDF portfolio by picking all their own mutual funds.

“Interestingly, the analysis found little benefit from this do-it-yourself approach,” CRR warns. “The reason is that individual investors who buy, say, Class A shares will pay more than the TDF itself pays for Class A shares, as the TDF has access to a lower-cost version of the shares due to its size.” Besides this, it will be difficult for an individual investor to match the consistency and professionalism of a professional TDF management team—a factor that comes into play when regular rebalancing is required. 

The CRR analysis goes on to suggest that investors may want to shy away from TDFs that promise to be overly tactical, despite the appeal of attempting to offer greater protections on the downside. “As noted, all TDFs have a glide path that determines how their stock-bond allocation changes over time,” the researchers say. “However, funds often deviate from their path to try to improve returns by responding to changing market conditions. The results show that, compared with strictly following the glide path, the average return due to market timing across all funds is -11.5 basis points [bps] per year … If the returns are weighted toward funds with a longer track record, the result is -14.1 basis points. In short, deviations from the glide path do not improve, and may even hurt, performance.”

The full issue brief, “Target Date Funds: What’s Under The Hood?,” is available for download here.