Your 401(k) plan options probably include at least one target-date fund. Some financial planners tout these funds as a way to keep your portfolio appropriately allocated throughout your working career all the way to retirement. But others think they're a disaster. Who's right?
First, a brief primer: Target-date funds are composed of several funds representing different investment styles or asset classes. As their name suggests, they have a target date, such as 2020 or 2040, for retirement (or in the case of 529 plans, for college matriculation). The investment firms running these funds make the asset allocation decisions on behalf of investors based on the target date.
Is simpler better?
Ronald J. Rough, CFA, director of portfolio management at Financial Services Advisory in Rockville, Md., says that target-date retirement funds try to make a complicated scenario — how to invest over 30 or more years — simple. Or at least simpler. They generally start out more heavily weighted in equities, then grow more conservative as your retirement date draws closer.
"Simplification" is one of the advantages of target-date funds, says Certified Financial Planner Benjamin J. Muchler, vice president and portfolio manager at Boston Research and Management. "This isn't a magic pill that guarantees a particular return or eliminates the risk of loss, but it brings a level of portfolio management and complexity that is typically out of reach (for most investors)," he says.
On the other hand, for Certified Financial Planner Jon L. Ten Haagen of Ten Haagen Financial Group in Huntington, N.Y., "simplification" may be part of the problem. Target-date funds "can be one-size-fits-all," he says, whereas your current situation, risk tolerance, other assets and retirement needs are very individual.
Rebalancing balancing act
Muchler says that one advantage of target-date funds is that they "take the responsibility for rebalancing out of the investors' hands. Even if investors do a great job of picking the right funds initially, it's unlikely they're going to review and rebalance them every quarter."
Rebalancing a portfolio can require selling what's doing well so that you don't become overinvested in one particular asset. "It's hard for people to sell the funds that are doing well and to buy the ones that aren't. Having someone else do the rebalancing takes the emotion out of it," says Muchler.
But Ten Haagen contends that most of these funds don't rebalance often enough. "They rebalance every few years at best — maybe every four or five years," he says. "If one had a fund in 2006 or 2007, they went from Dow 9000 to 14000 and back again." Without fairly frequent rebalancing, investors in these funds may have gotten hurt at the top of the market, with too much equity exposure, and at the bottom of it, with too much fixed-income exposure as the market rebounded.
It's what's inside that counts
Even if you're not retiring for another 20 years, Muchler suggests examining the company's target-date fund for current retirees to gauge what your portfolio might look like in the future. "If there are a lot of volatile assets in there, that could be a problem."
It certainly proved to be a problem during the market rout in 2008, when funds with a 2010 target date suffered losses of 23 percent on average, according to Morningstar, due to too much exposure to risky assets.
See if the fund with an imminent target date in your 401(k) lineup contains a mix of assets that you'd want in your year of retirement. In Muchler's experience, some people are too aggressive close to retirement. "They shouldn't be taking big bets on equity markets."
Rough agrees that this can be a problem: "We have folks who haven't saved enough for retirement and they want to take a lot of risks." A good target-date retirement fund would prevent that from happening.
But as Muchler points out, the allocation range varies greatly from one target-date fund to another. "There are companies that have you in 70 percent equities the year before retirement and others with 30 percent."
That reflects a difference in philosophy by investment management firms. Those offering funds with a high allocation to fixed income assume you will use the assets to buy an annuity at retirement, while those with high equity exposure assume you will leave the assets to grow in the fund through your retirement, extending your time horizon for 20 to 30 years.
Further, you'll want to investigate what funds they're actually holding. "This is where the biggest pitfalls occur," says Muchler. "Some companies use these funds as an easy way to boost sales of underperforming proprietary funds. If there's a fund that's struggling or that's new (and doesn't have a track record), they can keep it alive by adding it to a target-date fund."
Ten Haagen points out that in addition to a target-date fund being potentially too conservative or too aggressive, it may not be as diversified as you need, he says. "Does the fund have derivatives, real estate or commodities?" he asks.
The bottom line
To decide if a target-date retirement fund will work for you, you need to ask yourself how aggressive you are, what kind of risk you're comfortable with and what other financial resources you have, says Rough.
Keep in mind that you don't have to invest in the target-date fund that corresponds with your date of retirement, says Rough. If you're planning to retire in 2030, but want to be more aggressive over the length of your investment horizon, you can invest in a target-date 2040 fund. Or you can do the opposite if you prefer a more conservative approach.
You can drill down into the fund by reading the prospectus and the Web site associated with it. "Find out what funds and asset classes are used and how those change over time," says Muchler.
Ten Haagen also suggests looking at investment research information, such as that provided by Morningstar. "Is the fund consistently in the top quartile of its category in ranking and total return? If there's just one superstar manager, and he gets hit by a bus, who's going to take over?"
In the end, says Ten Haagen, "The bottom line is it's your hard-earned money. You should pay attention to it over time. ... If your approach is, 'I'm not going to pay attention to it,' then it's your fault that it doesn't work."