Target date mutual funds take the hard work out of building a diversified portfolio. And judging by their soaring popularity, investors appreciate the convenience.
Target date funds, also known as lifecycle funds, assemble different asset classes into a single portfolio with weights geared to a specific year in the future.
Target date funds, TDF, are most frequently used for retirement savings in 401(k) plans and IRAs with the target date being an investor’s expected retirement year.
The TDF structure is also used for 529 college-savings plans with the target date being a student’s college enrollment year. Fund managers handle asset allocation and rebalancing, shifting gradually from a growth objective to one focused on capital preservation and income.
TDF funds continue to attract new investors. Assets in such funds reached $334 billion in 2010, an increase of 82 percent over the last three years, according to Financial Research Corp. Among 401(k) participants, 33 percent now own a target date fund. And for college savers, 35 percent of 529 plans sold through financial advisors use target date or age-based portfolios.
Using TDFs effectively gives you the best chance of reaching your long-term goals. But before putting your savings on cruise control, take stock of these four common mistakes that can derail a target date approach.
1. Choosing the wrong glide path
Not doing your homework is the most common and curable error for target date investors. You should know that the target date is the year when you’re expected to shift from saving to spending. You’ll also want to study the glide path, the manager’s plan for shifting a fund’s allocation over time from mostly stocks to less risky assets.
“My sense is that investors don’t think about the glide path and how it works,’’ says Jeff Kostis, a certified financial planner in Vernon Hills, Ill. Not understanding glide paths can leave investors in allocations that may be too aggressive or may become too conservative too soon.
Retirement target date providers fall into two camps on glide paths. A growing number of firms target longevity risk — the chance you’ll run out of money in retirement — and maintain higher equity weightings at the target date and well into retirement. These types of lifecycle funds are known as “through retirement” funds.
Others worry primarily about market risk, the chance your principal will lose value, and shift to bond- and cash-heavy allocations by the target date. These are commonly called “to retirement” funds.
“The debate used to be how aggressive should you be at retirement,’’ says Steve Utkus, head of the Vanguard Center for Retirement Research. “ Now it’s how aggressive should you be into retirement.’’
2. Assuming all target date funds are the same
Look under the hood of funds sharing the same target date and you’ll discover vast differences in glide path, cost and management style. “There’s no consistency across the different companies and that creates a lot of problems,’’ says Kostis.
For funds with a 2010 target date, stock exposure ranges from a high of 67 percent to a low of 20 percent. For 2015 funds, the range is even wider: 75 percent for the most aggressive funds to 20% for the most conservative.
“That’s a huge difference in volatility,” Kostis adds.
Cost is another factor that can weigh on an investment, especially for TDF funds geared to retirement. In the 2030 category, expense ratios range from a bargain basement 0.18 percent for index-basedVanguard Target Retirement 2030
to 2.21 percent for actively managed, advisor-sold PIMCO Real Retirement 2030 .
Most target date funds are managed by mutual fund firms using their own in-house products, but critics like Baltimore certified financial planner Tim Maurer say sticking with a single provider is a bad idea.
If you feel the same way, take a look at multi-manager funds. These offerings are built like corporate pension plans, with different managers selected to run investments that are their specialty. Schwab, JohnHancock and Russell Investments follow this approach.
Not having a choice of TDF providers, however, should not deter 401(k) participants from using one. As long as the funds offer broad diversification across major asset classes at a moderate cost, the combination of underlying fund managers — active or passive — shouldn’t have a big impact on performance.
3. Relying solely on a target date fund
Target date funds are meant to be your one investment fund with diversified holding across all asset classes, but investors can also benefit from mixing a TDF with other funds. Adding style-specific funds can help investors adjust their risk level.
Sixty-two percent of Vanguard 401(k) participants who own funds in addition to a TDF do so to make their portfolio more aggressive while 56 percent add funds to improve diversification.
Investors more comfortable picking their own investments can benefit from TDF exposure.
“Even holding a small position in a target date funds eliminates the extremes of having a 100 percent or zero percent allocation in equities,’’ says Cyndy Pagliaro, a researcher at the Vanguard Center for Retirement Research, who adds that TDFs are a popular core holding in a core-satellite approach to investing.
Target date funds may not offer access to every asset class. Fund companies are adding less-correlated investments like TIPS, commodity funds, and real estate to their allocations. Even so, more seasoned investors may find the one-size-fits-all approach lacking.
Maurer says the biggest hole in target date funds is their international weightings. International stocks and bonds, which account for the lion’s share of global securities markets, offer among other things exposure to higher interest rates and foreign currencies.
“Most people should have more [international equities] than you find in most target date funds,” he says.
But don’t go overboard.
Roger Wohlner, a certified financial planner in Arlington Heights, Ill., has heard of investors spreading their assets evenly across five different target date funds from the same provider. “If people are going to mix and match they could get in trouble,” he says.
4. Forgetting about the distribution phase of retirement
A fund’s glide path doesn’t stop at retirement. With longer life expectancies, investors need to expand their focus from building wealth to prudently spending it. Target date managers understand this and continue to make adjustments past a specific target date.
Target date funds have taken heat for being too stock-heavy approaching retirement milestones, yet longer distribution — or retirement — periods make such allocations a necessity.
“A lot of people don’t understand the assumption that you’ll be in retirement for 20 to 30 years. They look at the weightings of equities and think it’s too much,’’ says Wohlner.
Vanguard’s Utkus points out that a higher equity stake can help guard against two of the biggest risks faced by retirees: general inflation and health care inflation.
Maintaining a TDF can also help offset implementation risk, the risk that investors will cash out of stocks during a selloff and get back into the market after a rally.