By FPA member Scott M. Kahan, CFP®
Last Updated: July 26, 2010
In a perfect world, wouldn’t it be great if you could figure out when you want to retire, pick an investment targeted to that date, put your portfolio on cruise control and then at retirement, have that investment provide the needed income throughout the remainder of your life? Lo and behold, there seems to be such an investment! They are called target-date funds or lifecycle funds. But, like with any investment, you should do your homework to find out if this is the right investment choice for your retirement portfolio.
What are target-date funds?
In theory, target-date funds should be easy to understand as essentially they are just a type of mutual fund. With target-date funds, a long-term investment strategy is designed to meet a particular retirement date. As the retirement date nears, the fund provider adjusts the allocation mix to become more conservative by shifting assets from equities to fixed income. For example, you will turn 65 in 2030, so you pick Target-date Fund 2030. Currently, that fund may have 70 percent equities, but by the time 2030 rolls around, equities may make up 25 percent and the remainder would be in fixed income.
In reality though, it is not that cut-and-dry, so you need to look at your own investment puzzle to see where this piece may or may not fit in. Further, with the increased popularity of target-date funds over the past years through employer sponsored plans such as 401(k)s, it’s important for you to understand the pros and cons of these funds as you may already be invested in one and not realize it.
Not all target-date funds are alike.
Even though the target-date may be the same from fund group to fund group, the allocation mix can vary significantly. Because under current regulations fund companies are not required to show the allocation mix at the target-date, investors often do not know what they are buying into for the future. This leaves investors susceptible to being exposed to market risk they may not be comfortable with. For instance, while one fund may have a 25 percent equity exposure at the target-date, a “similar” fund with same target-date may have a much higher equity allocation.
The Securities & Exchange Commission (SEC) is currently looking to force investment companies to have more disclosure to help clarify these investments. Among the requirements, fund companies would be required to show the asset allocation at the target-date. Also, the SEC may require investment companies to include a statement in their marketing materials warning investors to consider their risk tolerance and financial situation when investing.
Fees from target-date fund to target-date fund can also vary greatly and can often be higher than if you choose your investment portfolio yourself. The fees can really add-up with every adjustment that the fund manager makes to account for the necessary reallocation of assets. Remember too, that the higher the fee, the lower your returns may be.
What to look for when choosing a fund.
Whether you’re considering a target-date fund or a traditional mutual fund, you should always start by considering the management style. Is the fund manager’s approach too aggressive or too conservative for you? Take a look at the target-date fund’s glide path, which is the path that the fund will follow to become more conservative over time as with each fund that allocation will vary depending upon management style. Also, look at past performance and how it compares to similar type funds.
Because target-date funds are on auto pilot or considered passively managed, you need to review how a target-date fund choice fits in with other investment accounts you own. For example, if your chosen target-date fund is currently heavily invested in equities, you need to consider how this affects your total portfolio and possibly reallocate in the other accounts you have. Keep in mind too, that the lack of flexibility in target-date funds does not account for possible tax advantages that are recommended in actively managed retirement accounts. For instance, under current tax laws, it is often recommended that you have more fixed income in retirement accounts and growth oriented investments in non-retirement accounts. Finally, depending upon where the fund is in its glide path, the fund manager may not be able to take advantage of market conditions or get out of poorly performing asset classes. An example of this would be if you were in a target-date fund during the 2008-2009 downturn. If you were in the earlier part of the glide path, when the fund was weighted higher in equities, you would have lost significantly more money in your portfolio than if you had been able to reallocate to another asset class according to market conditions.
Closely monitoring the other pieces of your retirement puzzle will ensure that your allocations across the board are diversified and weighted where they need to be for current tax laws, market environment and economic conditions.
When do target-date funds make sense?
For investors with smaller accounts, target-date funds will provide diversification over a long-term period. They help to avoid the extremes in asset allocation that are seen between young and older workers as they each respectively tend to allocate too much towards equities and then too much towards fixed income as they near retirement. Investors who do not have the time or resources to actively manage their portfolio, transfer money on a regular basis between the asset classes and watch for market fluctuations that may impact risk, may want to use target-date funds as a component of their portfolio. As your account grows, however, you should consider looking at other funds to complement the target-date fund.
Play an active role in your retirement planning.
At the end of the day, as an investor in today’s fast paced environment, it is of the utmost importance that you be actively involved in planning your retirement and figuring out where your money is going. There will come a time in your life that you will need to have a better understanding of your investment choices. Take advantage early, when you have less money at risk, and learn about your investments and about planning for your retirement.
FPA member Scott M. Kahan, CFP®, is president and founder of Financial Asset Management Corp. (FAM), a New York City based fee-only wealth management and financial planning firm. He regularly serves as a valuable source for such media outlets as The Wall Street Journal, The New York Times and ABC Evening News.