Since the first one made its debut in 1994, target-date funds have increasingly gained in popularity among investors. Over the last decade, target-date funds have become a staple of 401k other retirement investment plans. With that being said, total assets invested in such funds have soared from $111.9 billion in 2006 to nearly $700 billion through February 2015.
Q: What exactly are target-date funds?
A: These are funds with a specific target retirement date – corresponding to an investor’s estimated retirement year – that are comprised primarily of cash, stocks, and bonds. Over time, the funds, which normally invest in a number of other, underlying funds managed by the parent company, gradually transition to a more conservative asset allocation as the target retirement date approaches. Individuals using these investments are freed from the burden of reallocating their assets as they age and are spared the duty of searching for suitable funds in various categories to build a well-diversified portfolio. While many companies offer funds of varying retirement years, these providers differentiate their offerings through unique allocation criteria. Currently, Vanguard, Fidelity Investments, and T. Rowe Price are the largest players in this space. With that being said, investors should be aware that these funds are not always the best choice for all investors.
The biggest advantage target-date funds enjoy is their simplicity. It is this characteristic that makes them appealing to individuals who do not have much investing experience. This “set it and forget it” mentality has caused the popularity of target-date funds to increase substantially, particularly within participant-directed 401k plans. Outside of retirement accounts, these funds could be appealing for individuals with smaller investment portfolios, such as those just beginning to save for retirement, since achieving proper diversification is more difficult with smaller account balances. In these cases, target-date funds offer a simple solution and allow such individuals to gain exposure to a myriad of underlying funds, achieving broad diversification with much lower capital. Aside from these situations, investors with more money to invest should keep in mind a few additional considerations before getting on the target-date fund bandwagon.
While target-date funds do offer some advantages, they also pose a few challenges and risks that investors should be aware of. First, target-date funds do not offer the same amount of flexibility as a custom portfolio because they follow one investment philosophy – that of the parent company. In addition, the target date funds are only comprised of underlying funds of that issuing company, thereby inhibiting the ability to pick the best investments across a wider universe. For instance, while one fund provider may have a strong lineup of U.S. equity funds to draw upon, it may not have the same expertise and research capabilities in the fixed income or emerging market areas.
Further, target-date funds falsely assume that all individuals retiring in a given year have the same financial circumstances and risk tolerances. For example, an individual that has steady sources of post-retirement income – such as a pension, rental property income, or part-time work – may be able to tolerate higher risk in his/her investment portfolio than an investor who will look to source the majority of his/her retirement income from the investment portfolio. Target-date funds do not take these details into consideration.
Finally, the most alluring quality of these funds, their simplicity, could ultimately be their largest downfall. Research suggests that this simplicity gives some investors a false sense of security and leads them to believe that they will be ready for retirement just by using a target-date fund. A 2012 study sponsored by the Securities and Exchange Commission (SEC) found that only 36% of respondents knew that target-date funds do not provide guaranteed retirement income. Furthermore, another 30% of individuals who owned target-date funds reported that they did not know the correct definition of “target date” in the name of the fund. Another mistake some investors make when utilizing these funds is combining target date funds with additional stock or bond funds, which can change the overall portfolio asset allocation and give the portfolio a different risk profile than what was initially desired.
Comparing Different Companies
While there are many target-date funds geared toward the same chosen year, they are far from the same in their investment approach. When investing in these types of funds, it is important to consider the glide-path taken by the parent company. Broadly, a glide-path refers to the formula used in order to adjust the mix of stocks, bonds, and cash in the portfolio in relation to the target date. Since different companies follow different glide-paths, their returns can vary significantly from year-to-year.
Considering the strong rally that the domestic stock market has enjoyed over the last seven years and the fact that interest rates continue to remain at low levels, the current investment environment could prove particularly challenging for target date funds given their lack of flexibility. Since target-date funds generally use the historical returns of various asset classes to determine their glide-path, these funds may have a harder time adapting to the market environment going forward, as we believe fixed income returns are likely to be lower than their historical average.
At Condor Capital, we believe that a customized, flexible investment approach is the best option for most investors seeking to build their retirement nest egg. For instance, over the last several years, we have maintained an underweight allocation to non-U.S. equities in our clients’ portfolios to reflect our greater optimism for the domestic economy versus the economies of other major nations. Even as the international piece has been lessened, we have sought diversified currency exposure by incorporating hedged currency vehicles to mitigate the impact of a rising U.S. dollar. Investors in funds with predetermined glide paths cannot take advantage of tactical shifts such as this.
In all, “set it and forget it” investment options do not take into account the current market dynamics or an investor’s specific circumstances. While target-date funds accomplish a few key goals and may be right for certain investors, they lack the flexibility and caution that is needed to get the most out of your money when approaching retirement.