Target Date Funds have been increasing in popularity and are now offered broadly within 401k and 529 plans. Money flow into these funds has continued to soar.
The name Target Date Fund (TDF) is based on the idea that money is invested with a target date in mind when an investor will need access to the funds. For 401ks this is typically the year of retirement or for 529s, the year a child goes to college. The target date fund invests in various mutual funds with percentages dedicated to equity and fixed income that gradually shift as the fund approaches the target date. The shift from stocks to bonds over time is called the target date fund’s glide path. The equity is typically high in the early stages when the target date is far away. The fund then automatically shifts the allocation to favor fixed income and cash, so that funds are more conservatively invested as the target date approaches.
This autopilot approach simplifies investing and eliminates the need for continuous monitoring and rebalancing. The good news is that TDFs have redirected investors, who typically stayed in low-yielding money market funds, to venture into the market and to do so with an allocation framework in place. Alternatively, investors who may have put everything in the stock market with little caution, now have a more disciplined methodology.
Though there are inherent benefits, TDFs are not a perfect solution. There are some drawbacks of which investors need to be mindful.
TDFs follow the one-size-fits all approach. TDFs can be a good fit when retirement is far-off, but there are many factors to consider along the way: total value of nest egg, financial commitments and medical issues to name a few. As investors approach retirement the financial picture becomes more complicated.
Inconsistency of Returns. Investors will see varying returns for funds with the same target date. This is because the underlying asset mix varies greatly from one fund to another. As the target date nears, the disparities among TDF glide paths become great. Some TDFs will take the equity allocation down to 20% over time while others will only lower it to 60%.
No Guarantee. There is no guarantee that investors won’t lose money just because this critical end date is near. Performance is particularly varied during extreme market conditions. In 2008 many funds that were close to their target date took large losses when in theory they should have been invested very conservatively with a percentage of the money held in cash.
Overall Asset Allocation. Asset allocation within the TDF is continually changing. Not only does it shift according to the fund’s stated glide path, but the manager can also make adjustments to that glide path and to the underlying investments. Transparency is lacking and it can be difficult to determine the specific exposure a fund has to riskier assets.
Use of Mutual Funds. Using funds as opposed to direct holdings of stocks and bonds gives an investor little control from a tax perspective. Holders of mutual funds inherit the tax basis of the fund. For example if the fund purchased IBM at $95 in 2009 and sells it today at $180, your capital gain is the full $85, even though you may have purchased the mutual fund six months ago when IBM was trading at $190. Portfolios are likely to have duplication of positions particularly when you hold funds in a TDF in addition to holding mutual funds in other accounts. Portfolios become over diversified and lack focus.
Assessing Performance. It can be difficult to assess performance against a benchmark. Funds with similar target dates on Morningstar can be used for comparison, but keep in mind the allocation of the fund under review may differ significantly from the fund on Morningstar with the same target date.
Restricted to One Fund Manager. Within 401k or 529 plans, the target date funds offered are offered by a single institution or fund manager. As a result, the underlying mutual funds selected in the TDF will be from that institution. It is unlikely that all funds from one manager are strong across all asset classes.
Note: Donna St.Amant, MBA, is a Portfolio Manager at Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Ave., Summit. The full-length version of this article is available at: www.ptview.com. CNBC has named Point View number 5 on its list of the top 100 American fee-only wealth managers. See http://www.cnbc.com/id/101619698
Point View Wealth Management, Inc. works with families in Summit and beyond, providing customized portfolio management services and comprehensive financial planning, to develop and achieve their financial goals. We are independent and fee only. How can we help you? Contact David Dietze (firstname.lastname@example.org), or Claire Toth (email@example.com), or call (908) 598-1717 to learn how.