Target-date funds

February 13, 2009

One retirement investment vehicle that has gained popularity in recent years is target-date funds. When setting up these long-term funds, investors designate their retirement dates, which become the target dates for liquidation so they can use the proceeds to pay for expenses during retirement.

As investors contribute to these funds during their working years, professional asset managers working for the financial institutions holding these investments allocate assets to a gradually changing mix of stocks and bonds. As investors in target-date funds grow older, coming closer to their target dates for retirement, money managers gradually decrease the funds’ proportions of equity investments and increase their allocations to bonds. Thus, investors are less exposed to stock market meltdowns—like the one last fall—that may occur soon before redemptions are taken on target dates for retirement.

The target-date fund industry calls this gradual shift of assets a retirement glide path, the metaphor being one of an aircraft delivering investors to their retirement destinations. Essentially, target-date funds are a way of jobbing out to money managers the responsibility and work involved in following the age-old maxim that individual investors should gradually reduce their exposure to equities as they age to control risk while gradually increasing bond holdings to assure a lower but reliably low-risk investment income to fund retirement.

Sounds logical, right? Well, it is. So these may be attractive investments for busy physicians who lack the time to monitor and reallocate their assets over time to achieve a suitable glide path on their own.

Yet the logic of target-date funds comes with complex dynamics that can affect these funds’ performance and play havoc with investors’ comprehensive retirement plans. Moreover, the market meltdown of 2008 has redefined the whole notion of market risk upon which target-date glide paths have long been modeled.

A fundamental controversy surrounding target-date funds is, ironically, whether they should end at the target date. Even before the 2008 meltdown, some target-date fund vendors had begun evolving their strategies to sustain glide paths long past the target dates for investors (like physicians) who can afford to postpone redemptions.

“Many funds can trap investors by managing their assets up to, but not through, retirement,” says Gregory P. Brown, a principal at Payden & Rygel Investment Management, distributor of Payden/Whilshire Longevity Funds. “This can leave retirees under-funded for living expenses or it can increase the potential for them to take excessive investment risks… Just as you wouldn’t recommend an airline that stops on the runway, you wouldn’t want a target-date fund that couldn’t bring you safely to your destination.”

Advocates of this strategy say it has the advantage of spreading market risk over a long period, thus reducing its intensity around the time of the target date. This is particularly advantageous concerning risk in equity markets.

Though investors who were burned by the equities market decline last fall may be able to embrace this approach, some analysts argue that making the glide path too long—for example, by extending a 10-year target-date fund an additional 10 years after the investor retires—involves inherent risks. Those opposed to this extension say these risks show up in extensive technical modeling of the likelihood of a given glide path’s having the capacity to pay off for investors. No matter what the stock-bond mix, if the fund runs too long, these critics say, returns can suffer.

“Target-date funds are a great idea that’s likely to serve investors better than if they were left to their own devices,” say Ron Surz, a pension consultant who is president of PPCA and a principal of RCG. “But typically, we think target-date funds’ execution has a lot of room for improvement, and I’m spelling “LOT” with big letters…Our position is that the actual target date should be the end. Our research shows that there’s no glide path in the world that can serve investors from cradle to grave. There’s no glide path that we can think of that would serve investors in the distribution phase.”

Proponents of extending these funds past the target date acknowledge that taking distributions while continuing the fund can change performance, but argue that if this is done correctly, the fund can continue to perform well. Regardless, high net worth investors such as physicians can always cash out their target-date funds and hang onto other securities investments, especially bonds, to provide low-risk income well into retirement.

Advocates of extending the target-date funds past the target date maintain that doing so can reduce some of the risks inherent in these funds, including longevity risk—the chances that retirees will outlive their retirement assets. If accumulations are allowed to continue post-target-date, goes the logic, then there will be more assets remaining as investors advance well into their retirement years. Similarly, these advocates argue, these extended target-date funds can counter the risk that inflation will eat away at retirement assets. “Inflation risk can be managed with target-date funds that balance capital accumulation and capital preservation,” Brown says.

Even for investors inclined to retain target-date funds beyond the designated date, this consideration hinges on another set of circumstances that’s crucial to their overall investment success: whether (and if so, how) assets in a target-date fund jibe with the investor’s comprehensive asset allocation.

Holders of target-date funds shouldn’t think of these investments as an isolated island, but rather one locale in an archipelago of assets. For example, when setting up a target-date fund, take care not to repeat equity market sectors to which you already have substantial exposure in other vehicles. Instead, use the fund to increase, rather than decrease, your portfolio diversification for the long term.

When considering target-date funds, the best course of action is to take time and care to evaluate them as part of your broader retirement plan. Above all, be aware that making changes in your non-target-date assets will affect the legitimacy of your asset allocation within a target-date fund.

If you haven’t the time to keep up with this, consult a financial advisor. When doing so, keep in mind that many advisors unaffiliated with target-date funds may not be keen on them because they prefer to get clients into investments that require more management—their management, of course. Yet some advisors are willing to discuss target-date funds as part of a larger portfolio strategy.

Richard Bierck (richbi@comcast.net) is a financial writer, editor, and editorial consultant based in Princeton, N.J.

One retirement investment vehicle that has gained popularity in recent years is target-date funds. When setting up these long-term funds, investors designate their retirement dates, which become the target dates for liquidation so they can use the proceeds to pay for expenses during retirement.