For the 401k plan participant defaulted into Target Date Funds, this article will address the automatic asset allocation strategies inside these funds.
The chances are getting much higher that your company has adopted a default investment option in your 401k plan. A recent survey by Hewitt Associates suggested that automatic investment into Target Date Funds rose from 50% of plans in 2007, to 69% of plans in 2009.
For some plan participants this automatic feature may be a relief. The marketing material for these funds suggests that the automatic, asset allocation strategy used as well as the automatic, annual rebalancing are all that an individual investor need to sail comfortably into retirement. Yet, this, in fact, may not be the case.
The asset allocation strategy assumption which is the engine underneath the hood of this product is the prudent investment portfolio for every investor is a predetermined mix of stocks and bonds based on the investor’s age. Furthermore, the assumption is that as the investor gets older, bonds should represent a greater proportion of the investment portfolio. The assumption is that bonds preserve capital, in other words, are risk free.
Know that every Target Date Fund uses bond funds as a proxy for bonds. Know too that bond funds lack the one characteristic which makes bonds a “safe” investment – a maturity date. Without a maturity date bond funds are forever exposed to interest rate risk. Why? Because it is only on the maturity date that a BOND investor is at least promised a return of 100% of their investment. Interest Rate Risk is the reality that as interest rates rise, bond values fall and as interest rates fall, bond values rise.
If you look carefully at the credit rating of the bonds inside the bond fund portion of your Target Date Fund, you may be shocked. One would expect the managers to limit their bond allocation to AAA rated paper or at least “investment” grade. Yet, upon examination of at least one plan the author noted a surprising amount of bonds below “investment” grade. So how safe is the safe investment in the asset allocation strategies used by default Target Date Funds? Do not assume this default investment is in your best interest; and, do not assume you are getting 401k advice.