Target-date funds continue to be a popular choice for millions of people's 401k. Target-date funds got a big boost in 2006 when the U.S. Department of Labor identified them as an eligible default investment within defined contribution plans. According to Morningstar, Target-date funds had more than $500 billion in assets in the first quarter of 2013.
It's easy to see the appeal. “You get a set it and forget it portfolio that changes with you as your time horizon changes. Basically, your asset allocation modifies as your time horizon changes. You are essentially outsourcing your portfolio management to the mutual fund company, which automatically changes the asset allocation in your portfolio as your time horizon changes,” explains Todd Douds, senior vice president at Fort Pitt Capital Group.
Basically, target-date funds diversify assets across multiple asset classes, then use a glide path (pre-determined change from a higher equity allocation to a lower equity allocation) designed to adjust holdings in ways that reduce portfolio risk as you near retirement, says Tim McCabe, senior vice president, national sales director and overseer of Stadion Money Management's retirement offerings.
Post-2008, returns of Target-date funds have been strong, according to Morningstar. All but Morningstar's Target Date 2000-2010 category posted double-digit returns for 2012, and all but one peer group – Target Date 2051+ has recouped losses from 2008's market crash.
But for all that good news, Target-date funds are far from simple. In fact, there's much to think about before investing in a target-date fund.
Target-date funds anything but simple
“There are dramatic differences in TDFs. Holdings can differ significantly from one TDF lineup to another, in terms of how much and what types of securities make up the allocations,” warns McCabe. In addition, glide paths can be radically different. “One 2010 fund may have 50% equity exposure at retirement, and another, as low as 5%. Investors need to know what they own,” he says.
In 2008, some of the 2012 maturity target-date funds were down a large percent, when investors thought their portfolio was in a safe and conservative zone, says Douds.
McCabe says most target-date funds are not designed to offer protection from disastrous market declines since they are limited to a static (strategic) investment strategy that does not allow for drastic portfolio adjustments that reflect changes in market conditions. “We believe age-based adjustments need to be complemented by market-condition based adjustments in order for investors to have the best chance at reaching long term goals with tolerable volatility,” says McCabe.
Matthew Tuttle, certified financial planner with Tuttle Tactical Management is frank. “Target-date funds are a ticking time bomb. The idea that you should base your asset allocation on your age relies on the fact that bonds have been in a 30 year bull market and have been a portfolio risk reducer for that entire period. This is coming to an end and bonds will become risk enhancers,” he says.
This means that someone nearing 65 will be shifting out of an asset class that is increasing in value, stocks, into one that is decreasing and has very little, if any potential upside, says Tuttle. “The result will be a disaster. Instead of basing allocation off of age, it should be based on what the market is doing. The market doesn't care if you're 65 or not.”
Roy Laux, vice president of Synergy Financial says his chief concern is, “the fact that portfolios are being adapted based on a target date, rather than a target economy. Is there a such thing as buying the wrong asset class at the right time? With the target funds, unfortunately the answer is yes.”
What about your personal preferences?
“Just because you select a fund that matches your retirement year, that doesn't mean it is the proper fund for you,” explains ReKeithen Miller, a certified financial planner with Palisades Hudson Financial Group. For example, if you have a higher risk tolerance and would like to maintain a higher weighting to stocks through retirement, you may consider investing in a target-date fund that has a date that is well after you expect to retirement, for example, 2030, instead of 2020.
Keep your eye on the prize
Forget the notion of set it and forget it once you buy a target-date fund. “As with any investment, you still need to monitor the fund's objectives and investment strategy. If not, you may find that the target-date fund you invested in missed the mark,” says Miller.
As always, do your research. Says Douds, “Target-date funds are not the silver bullet.”