Lifecycle funds, also known as “target date” funds (TDF), are popular investment choices found in many company retirement plans. They are also being marketed to individual investors through mutual funds as a single, one-stop investment solution. Lifecycle funds have a simplistic concept which may not be such a bad idea. The concept is that these funds, primarily using a mix of cash bonds and stocks, steadily become more conservative as the account holder ages. The funds typically have names that include the desired year of retirement (i.e. “Retirement 2045 Fund”).
An advantage of TDF’s is that they can help keep retirement plan participants fully invested and focused on building long-term growth retirement savings. New contributions from participants previously were often parked in low-earning cash or money market funds as the default investment choice until specific instructions from the account holder were made.
Lifecycle target date funds are not generic in nature and can actually be quite complex. A common misperception among many investors is that funds from different providers with the same target year in the name will have very similar investment philosophies and identical risk and reward profiles. When using lifecycle or target date funds it is important for investors to have a clear understanding of the design of their specific fund.
Perhaps the most important concept to understand is known as the “glide path”. This design feature determines how much of the fund assets are invested in stocks as the target date of retirement approaches. A glide path “to” the date of retirement gradually reduces exposure to stocks up to the specified year of retirement and then typically levels off at a stock allocation around 30%. A glide path “through” the targeted retirement date typically maintains a decreasing allocation to stocks through the date of retirement plus 20-30 or more years covering average life expectancy in retirement. A “through” glide path often, but not always, maintains a 25-30% allocation to stocks in the later years. The spot where the glide path levels off is called the “landing point”.
There are a few potential drawbacks to using target date funds:
- There is no standard definition from company to company for the design of the glide paths.
- Target date funds assume all investors have the same financial needs and risk tolerance.
- TDF’s are often a collection of proprietary, in-house mutual funds. The proprietary nature opens up the possibility of higher fees or poor performance from some of the underlying funds.
- There could be a lack of transparency regarding the total cost of these funds due to additional underlying fund charges.
The most significant problem with target date funds, however, may be the lack of protection during times of stock market turmoil. In 2008, during the global financial crisis, the average “2010” target date fund lost 25% of its value. In other words, a typical investor within 2 years of a planned retirement date would have lost 1/4th of the value of his entire retirement savings.
Here are a few points to consider when evaluating target date funds:
- Does the fund follow a “to” or a “through” retirement date glide path?
- When does the glide path reach the landing point and level-off?
- What is the past history of the fund and the experience of fund management?
- What is the trade-off between investment risk and the risk of outliving assets?
- Are total fund fees transparent and not excessive?
- Is the fund manager allowed to deviate from the glide path explained in the prospectus to make tactical (market-timing) adjustments?
To summarize, lifecycle target date funds are becoming an increasingly significant component of most investors’ company retirement plans. It is important to research a particular fund, understand the potential risk-reward trade-offs, and how the fund allocation will evolves over time. On a final note, remember that lifecycle target date funds are long-term investments and probably not a suitable place to park funds needed to meet short-term goals. Also, use of these funds does not guarantee that the individual investor will be saving enough for retirement.
By Christopher Parr, CFP® is a River Hill resident and President of Parr Financial Solutions Inc.
– An independent, fee-only financial advisory firm: www.ParrFinancialSolutions.com