Target Retirement Funds

by

Jack Piazza
Sensible Investment Strategies

Target retirement funds are also known as target-date retirement funds, target-maturity funds or life-cycle funds. The popularity of these funds has dramatically increased since 2004; in fact, target retirement funds account up to one-half of sales at several fund companies. Let's review the background, the basics, the pros and cons for these target retirement funds.

 Background 

Asset allocation funds have existed for many years. Originally, they consisted of stock funds (both domestic and foreign), bond funds and a money market fund -- all within the same fund company; the allocations would be subject to change for general market conditions at the fund managers discretion. Some fund companies have expanded the allocation focus to include various risk levels of growth objectives and also an income allocation fund.

A few fund companies (notably T. Rowe Price in the fourth quarter of 2002 and Vanguard in the fourth quarter of 2003) began to emphasize asset allocation funds by including an estimated date of retirement. In other words, they believed the basic concept of the fund of funds approach would be much more marketable to investors if more focus was given to a specific goal -- retirement! Furthermore, the fund companies believed that these target retirement funds would appeal to investors who would not want to either hire an adviser or conduct extensive research by themselves to obtain portfolio recommendations. This concept also would benefit companies that have 401(k) plans by (1) simplifying investment decisions by participants and by (2) eliminating the potential dilemma of fiduciary responsibility by the company.

 The Basics 

Target retirement funds employ a fund of funds approach with a specific time horizon, reducing the stock fund allocation in favor of increased bond fund allocation as the target date approaches. The following chart from T. Rowe Price depicts allocation percentages for stock, bond and cash for years before and after retirement:

Other fund companies may favor different allocation percentages; some are more conservative with higher bond allocations while a few are more aggressive with high stock allocations, even with similar time horizons.

Regardless of the allocations, ideal characteristics for any target retirement fund should include diversification spread over various stock and bond fund categories. The target fund should include: large, mid and small-cap domestic stock funds; foreign stock funds; various corporate, government and high-yield funds in the bond allocation.

Since all target funds are comprised of individual funds within the same fund company, it is important that investors review these underlying holdings. All of these individual funds should have good performance history, well-defined strategies, experienced managers and below-average operating expenses. Retirement funds should also be no-load -- there is no reason for investors to pay a commission for these funds.

For comparison purposes, the Morningstar Fund Screen currently splits target retirement funds into five-year increment groups after year 2010; Morningstar previously had three groups, but this was too broad-based for accurate comparison ratings. Select "domestic" under fund type, then select the appropriate target-date range under fund category along with any other criteria and then click submit.

T. Rowe Price offers twelve-thirteen  individual active-managed funds (plus one index 500 fund) in their target fund offerings while Vanguard offers six-seven broad index funds in their target funds; both companies are no-load. In my opinion, investors do not need more than fourteen underlying holdings in a target retirement fund since this would likely lead to fund category overlap (i.e., several funds having the same characteristics resulting in unnecessary duplication). For a related topic, go to Three Common Mistakes in Mutual Fund Investing.

 Pros and Cons 

Target retirement funds offer a one-stop, easy to use, exposure for a stock and bond allocation strategy geared for a specific retirement date. It removes the guesswork for effective ongoing diversification and future rebalancing. These funds are an especially viable choice for 401(k) plans since most participants (1) do not have access to financial consultation and (2) are often overwhelmed by the many fund choices and, more importantly, (3) are mystified by the challenge to determine an appropriate allocation strategy.

However, the one major disadvantage of target retirement funds is the absence of different risk tolerance levels (conservative, moderate or aggressive). In other words, some advisers view these funds as "cookie cutters" in that one size fits all. For example, since it is unlikely a 401(k) plan will offer target funds from more than one fund family, this means investors would choose one target fund that best fits their time horizon, using the level of risk tolerance that the fund family chooses for that particular target fund -- their level of risk tolerance may be different from your risk tolerance. Consequently, one may be undertaking significantly more (or less) risk than normal.

Not all fund companies have similar allocations or fund categories. For example, across the broad time horizon spectrum, T. Rowe Price has a higher stock percentage, including a higher concentration of mid-caps and foreign individual funds than Vanguard, although Vanguard has significantly narrowed the gap. Some investors may have a very conservative risk tolerance and may need to include more conservative funds in their 401(k).

Another potential disadvantage of target retirement funds is the inclusion of mediocre or poor performing individual funds, which can negatively affect returns; always review the long-term past performance of these individual funds before committing to them. One more potential disadvantage, especially in view of the general market downturn in 2008 and the first two months in 2009, is the very high percentage of equities in some target retirement funds for individuals who are soon to retirement or in retirement -- in these instances, individuals should adjust their allocation in other holdings (401k, IRA and/or taxable accounts) to maintain an appropriate overall portfolio allocation.

 Retirement Income Funds 

Note the significant difference between "target retirement" funds and "retirement income" funds, most of which were created in 2008: retirement income funds invest in a mix of stock and bonds and employ a managed-payout strategy. These type of funds promise to make periodic payments until a set expiration date (e.g., 2020); at that time, your account would be zero. The specific income payouts, based on a fixed percentage of assets, are not guaranteed and are subject to the ups and downs of the funds holdings; the payments reset annually to reflect the gain or loss for the fund in the previous year. In contrast, you determine the particulars for any withdrawals in target retirement funds.

 Conclusion 

Target retirement funds, especially in a 401(k) plan, present a worthwhile alternative for investors who can select just one fund and thus avoid confusion in constructing a portfolio for specifically geared for retirement. In fact, these funds very likely promote increased participation in 401(k) plans due to their one-stop simplicity for both diversification and rebalancing for an allocation strategy.

Alternatively, investors who either do their own research or have access to an adviser are more likely to choose a customized portfolio that specifically addresses their return objectives, time horizon and particular risk tolerance. For related topics, go to Best Types of Mutual Funds for IRA and 401K Portfolios, The Role of Risk in Mutual Fund Strategies and Portfolio Changes in Retirement.