The highs and lows of target date funds — and what investors should know

Target date funds have grown into the most popular investments for 401(k) plan participants, but they carry some volatility near retirement and they're changing quickly, a new study found.

Defined-contribution plan assets held in target date funds topped $2.8 trillion last year — which is over a quarter of the retirement savers' holdings, according to a report released in April by the U.S. Government Accountability Office, a federal watchdog agency that reports to Congress. Low fees, automatic enrollment and the simple concept of choosing an estimated retirement year reflected in the name of the fund have fueled the inflow of assets since a 2006 law sought to encourage more employers to help workers start 401(k) plans and invest for the long term.

Unfortunately, in a recent example in line with critics' past warnings about target date funds' volatility, many investors sustained losses at the outset of the pandemic in 2020: the average product supposedly timed for retiring that year or close to it declined 8% from February to March. In addition, as plan sponsors and their financial advisors increasingly drive lower costs in 401(k)s and other retirement plans, target date funds are moving into the even cheaper structure of collective investment trusts that are overseen by different regulators and offer less information to investors. The GAO called for the Department of Labor to update two guidance documents that haven't been refreshed in more than a decade to reflect new trends.

The 2020 volatility registered as "just a little blip" compared to "the real damage" of the financial crisis of 2008 and accompanying Great Recession, in which 2010 target date funds dropped by roughly 30%, according to Ronald Surz, the president of San Clemente, California-based investment management and due diligence firm Target Date Solutions. For target date investors, the next recession is "a time bomb just waiting to go off," considering that there are tens of millions of baby boomers "in the risk zone" in the early phase of retirement or close to it, he said.

Retirement plan participants "think somehow their plan sponsor has put them into a vehicle that can't possibly lose value when they retire," Surz said in an interview. "They're definitely not getting the safety that they think they're getting and want."

READ MORE: Retirement plans' newest legal battle: low-fee funds, not high-cost ones

How the market came to be this way
Target date funds work through what is known as a "glide path" toward a particular year, with a decreasing share of the investment mix in riskier assets such as equities and a growing percentage in less-volatile holdings such as fixed-income securities. Generally, the products may differ in terms of shifts in their makeup "to" the retirement date or "through" them. The Pension Protection Act of 2006 "included provisions designed to facilitate greater adoption of automatic enrollment" in 401(k) plans, where Labor's rules for "safe harbor" have designated target date funds as a "qualified default investment alternative," the GAO report said.

In turn, much of the flows into the funds' assets in the years after the legislation stems from automatic investments, to the tune of 98% of Vanguard's defined-contribution plans using the target date products as the default option by 2022, according to the report. Notably, 59% of Vanguard's defined-contribution plan participants held a single target date fund as their only investment that year. And that could prove problematic during a recession or a sharp downturn like the one in February and March 2020, when target date funds for 2060 lost 14% of their value and those focused on 2020 dropped 8%.

"Variation in TDF design affects their performance and risk," said the report by Tranchau "Kris" Nguyen, a director in the GAO's education, workforce and income security team. Within a decade of the retirement date, the baskets of holdings among various target date products displayed more variety, Nguyen noted.

"While TDFs closer to their target dates experienced smaller losses in March 2020 than those further from their target dates, their performance varied more," she wrote. "This was due to more variation in their investment mixes. Negative returns are significant for participants close to, or in, retirement because they have less time to recover from them than those who are further from retirement."

Focusing closer on that month, the 2020 "through" mutual target date funds displayed a higher standard deviation than those for 2060, meaning that they came in higher based on "a common measure of a fund's volatility — and therefore its investment risk," according to the report. 

"This means that during that month, the performance of 2020 TDFs varied more than the performance of 2060 TDFs," Nguyen wrote. "In fact, at multiple points from 2019 to 2021, we found that 2020 TDFs had a considerably higher standard deviation than 2060 funds."

Others have noticed the substantial correlation between stock and bond performance with that of target date funds. During the Great Recession, funds in investment research firm Morningstar's target date 2000 to 2010 category took losses of 34% from their highest to their lowest points, according to a 2022 study by Josh Charlson, a director of manager selection with the company. His piece examined four questions for investors and advisors to consider in light of the volatility two years ago.

"When markets drop significantly, target date funds do too," Charlson wrote. "They are not guaranteed investments, and most — especially those intended for younger investors — carry significant allocations to stocks. Those younger investors needn't blink over even fairly big losses, because their very long horizons until retirement give them more than enough time to ride out the rough periods. The story is a bit different for investors very close to, or just entering, retirement."

READ MORE: The problem with your retirement plan's target date funds

Shifting to trusts — and a different regulatory structure
This subtlety within presumably simple investment funds is playing out in more ways, too. The funds' expenses have been falling over the years in a shift that has been accelerated by their migration from a traditional mutual fund structure to being collective investment trusts. 

In 2022, the collective investment trusts drew 79% of the inflows into target date funds, and their share of the assets in target date products expanded by 10 percentage points over a decade to 47% by the end of that year, according to Morningstar data cited by the GAO. To be sure, mutual funds are shedding fees: the average asset-weighted expense ratio for mutual target date funds dropped to 32 basis points in 2022 from 60 a decade earlier. Collective investment trusts' costs are even smaller, though. One asset manager's collective investment trust charged 23 basis points for its 2025 target date fund, while the mutual fund version of the product cost nearly twice as much at 45. 

The regulation of the products accounts for the difference, according to the report. While they work in much the same way as mutual funds, the adoption of collective investment trusts alters the regulators overseeing them to the Office of the Comptroller of the Currency and state agencies rather than the the Securities and Exchange Commission. That means that the asset managers don't need to register the products with the SEC or pay for the cost of compliance with its rules. The collective investment trusts are less likely to face enforcement cases, too.

"Regulatory actions and matters requiring attention have been minimal for collective investment trust TDFs, according to OCC officials," Nguyen wrote. "For example, no recent regulatory actions have occurred for collective investment trusts that include a target date strategy. In addition, of OCC's matters requiring attention from 2017 through 2022 that are related to collective investment trusts, none focused on TDFs."

Besides the lack of enforcement, the issuers of collective investment trusts aren't required to provide participants with a prospectus "and must instead provide a written plan document upon request from participants who invest in the fund," according to the report. Even Morningstar has struggled to track down basic information about them.

"In contrast to mutual fund TDFs, limited information is available about fees for collective investment trust TDFs," Nguyen wrote. "Morningstar representatives told us that because managers of collective investment trust TDFs are not required to publicly disclose fees for their funds through a prospectus or similar document, Morningstar requests that they provide fee data voluntarily. However, many asset managers do not provide this information. Among the collective investment trust TDFs included in their database, fee data were available for about one-third of them."

READ MORE: Why CITs are gaining 401(k) market share from mutual funds

Hopes for reform?

In light of the report's findings, the GAO recommended that Labor bulk up its 2013 guidance to sponsors and 2010 guidance for plan participants to include more information about "recent TDF developments" such as the collective investment trusts and the distinction between "to" and "through" target date funds. Labor rejected the ideas.

"The officials said the agency has had to prioritize initiatives that are linked to Secure 2.0, and these initiatives use already constrained staffing resources," Nguyen wrote. "The officials also

said the purpose of the guidance documents is to offer general direction and should not serve as a substitute for the advice of investment professionals. In addition, officials said that both guidance documents are balanced, accurate and appropriately highlight the general issues and processes that plan sponsors and participants should consider." 

"However," the report went on, "the 2010 and 2013 guidance documents do not provide information about certain details related to TDFs that have evolved since the guidance was issued. Without such information, plan sponsors and plan participants may have difficulty making informed decisions."

For Surz, the GAO's report read as "really watered down" and missing "some great opportunities to try to reform the industry" considering some of the alarm bells raised by the possible risk in target date funds, he said. 

He contends that target date funds should more closely resemble the structure of the "G-fund," which is guaranteed against loss for participants in the federal government's Thrift Savings Plan, and hold more safe assets such as short-term treasuries or treasury inflation protected securities.

"Autoenrollment solved the problem of participation," Surz said. "But then they created a new problem, and that was that people who were automatically enrolling didn't know how to invest."