Investors in some target-date “lifestyle” retirement funds, supposedly targeted to be more conservative as one approaches retirement, are unaware the fund managers are chasing yield to seek performance at exactly the wrong time.

Please consider Target-Date Retirement Funds Use Junk Bonds for Yield.

John Hancock’s Lifecycle 2010 mutual fund is marketed as an investment that “becomes more conservative” for people approaching retirement age. Thirty- five percent of the fund’s debt holdings in September were junk bonds, according to Morningstar Inc.

Six of the nine largest U.S. target-date fund providers by assets have high-yield corporate bonds in their 2010 portfolios, according to Morningstar. Target-date funds may present greater risks than consumers have been aware of, said Laura Pavlenko Lutton, editorial director in Morningstar’s mutual-fund research group. The funds grew into a $311 billion business by 2008, a year after the U.S. Department of Labor said employers may use them as an automatic enrollment investment option for 401(k) retirement plans.

Target-date funds, also known as lifecycle funds, move money from riskier investments such as stocks to more conservative alternatives like bonds as an investor approaches retirement. Last year, 7.3 million Americans held target-date funds, according to the Employee Benefit Research Institute’s database of 24 million 401(k) participants.

Other 2010 retirement funds with bonds rated below investment grade include: Principal Funds’ LifeTime 2010 Fund, at 21 percent of its total debt holdings; the Fidelity Freedom 2010 Fund, 17.1 percent; T Rowe Price’s Retirement 2010 Fund, 13.1 percent; American Funds’ American 2010 Target Date Retirement Fund, 11.4 percent and TIAA-CREF’s Lifecycle 2010 Fund, 6.6 percent, as of the latest portfolio disclosure according to Morningstar, a Chicago-based investment-research firm.

Vanguard Group’s avoidance of high-yield bonds is “very conscious,” said John Ameriks, head of the company’s investment counseling and research group. Junk bonds wouldn’t add “significant diversification,” and would raise expenses, he said.

Lack of disclosure on investments in target-date funds is one of the biggest problems with employers using them as an automatic option, said Richard Michaud, president of New Frontier Advisors, a Boston-based investment advisory firm.

Discovering what’s inside a target-date portfolio takes detective work, said Morningstar’s Lutton. An investor receiving a semi-annual report for Fidelity’s Freedom 2010 Fund, for example, would need to read through to page 20 to find the allocation in its high-yield fixed-income funds. The report doesn’t break down the percentages of bonds rated below investment grade. Investors may access that data by looking up the fund’s report by Morningstar and clicking on the “Portfolio” tab.

Fidelity’s Freedom 2010 fund held 25 underlying funds, according to Bloomberg data.

“The fact that these investments are so complex and the disclosure is not so robust makes it challenging for the individual to know what’s in there,” Lutton said.

High Sales Charges, High Risk, Low Performance

Thanks to Bloomberg writers Margaret Collins and Jeff Plungis for alerting unsuspecting investors of the risk. There is still more information in the article.

Lifecycle 2010 Portfolio

Inquiring minds are investigating a couple of the funds mentioned in the article starting with John Hancock Lifecycle 2010 Portfolio.

The Portfolio seeks high total return until its target retirement date. To pursue this goal, the Portfolio, which is a fund of funds, invests, under normal market conditions, substantially all of its assets in Underlying Funds using an asset allocation strategy designed for investors expected to retire in 2010.

Please note the POP (Public Offering Price). From John Hancock…

POP (Public offering Price) figures reflect maximum sales charge in class A shares of 5% for equity funds and 4.5% for fixed income funds with the exception of the Floating Rate Income fund, which has a maximum sales charge of 3%.

That disgustingly enough helps explain why these funds are chasing yield. Please note the maximum sales charges of 4.5 percent to 5 percent. It is extremely difficult to quickly make that back without taking on a lot of risk. Indeed it is nearly impossible to make that back in fixed-income without taking a lot of risk, even over time.

Those entering the fund this year did very well, but the 3-year track record was a poor -8.71%, just as investors heading into retirement will be needing to draw down those funds.

Five percent sales charges for this kind of performance is unconscionable. Heck, any sales charge for that kind of performance is questionable.

Straight up, one has to question if a thirty-five percent position in junk bonds is at all appropriate for those close to retirement. In my opinion, employers are not doing their employees any favors by offering such products.

American Funds 2010 Target Date Retirement Fund

Next consider American Funds 2010 Target Date Retirement Fund

This chart from the website says about all you need to know.

This fund sports a 5.75% maximum sales charge but “The fund’s investment adviser is currently waiving a 0.10% management fee.” How nice.

These funds are do one thing: Make big commissions for the sales staff offering the plans.

I repeat, five+ percent sales charges for mediocre to poor performance are unconscionable. Employers are not doing their employees any favors by offering such products. The only way to make up those charges is to take on risk and hope it works out over time. By now, people heading into retirement should have just about had enough of excessive risk.


A manager for a respected hedge fun pinged me with this comment:

“Target” funds are not a bad idea in principle. But, they have become a vehicle for ridiculous fees. In addition to the fees you mention, these are “funds of funds” so there are fees on the underlying funds as well. Given the modest (6% nominal per year or thereabouts) return expectations of these funds, an additional 2%-3% per year in fees is heavy going.

Addendum 2:

Michael, a financial consultant writes:

The sales charges you cite are for ‘A’ shares, not retirement shares. Most companies, and I know for certain true in the case of Hancock and American Funds, have retirement plan shares with much different cost structures than the publicly available counterparts. American Funds carry no load going in or out at all, though management expenses vary depending on the share class selected, with comp to the adviser on the plan varying between nothing (R-5 shares) and 1% (R-1) shares and everything in between. Employers aren’t doing their employees a disservice based on fees though they may be do so based on fund selection.

I enjoy your work.

Mike “Mish” Shedlock
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