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Financial Planning: the right target-date funds strategy for clients

Christopher Parr was quoted extensively in this article by Donald J. Korn on target-date funds strategy (or TDFs) in the September, 2016 issue of Financial Planning Magazine.

Parr discusses two approaches advisers can take when using TDFs in client portfolios.

  • “Some funds have a glide path to the date of retirement, gradually reducing exposure to stocks until the specified year of retirement and then leveling off,” says Christopher Parr, CEO of Parr Financial Solutions in Columbia, Maryland.
  • Alternatively, a TDF on a glide path through the targeted year typically has a higher allocation to stocks at that date, but decreases equities afterward.

While real life might throw a curveball to advisers who see themselves on the “through” side, Parr says, “My preference is to keep reducing equity allocations as retirees grow older.” He tells of a client who is in his 90s with a moderate-risk portfolio. “He’s comfortable,” Parr says, “so he’s not changing his allocation.

Thus, the portfolio brought to retirement may be fine all the way through. Or, as Parr observes, some clients are reluctant to adopt a more conservative stance because “nobody wants to face up to getting older.”

River Hill Magazine: Lifecycle Target Date Funds – A useful investment tool and not a one-stop shop

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:

  1. There is no standard definition from company to company for the design of the glide paths.
  2. Target date funds assume all investors have the same financial needs and risk tolerance.
  3. 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.
  4. 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:

  1. Does the fund follow a “to” or a “through” retirement date glide path?
  2. When does the glide path reach the landing point and level-off?
  3. What is the past history of the fund and the experience of fund management?
  4. What is the trade-off between investment risk and the risk of outliving assets?
  5. Are total fund fees transparent and not excessive?
  6. 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.

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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

 

The Business Monthly: Lifecycle Target Date Funds – Not a Holy Grail Investment Plan

hybrid investment products

Source: Swamp Meadow Community Theatre\

As the 40th anniversary reunion of famed comedy troupe Monty Python takes place in London this summer, it seems an appropriate time to mention a very different perceived Holy Grail of company retirement plan investing – namely “lifecycle” or  “target date” funds (TDF).  These hybrid investment products are being marketed to the masses by mutual fund companies as a single, one-stop investment solution.

Lifecycle Funds and Target Date Funds Explained

Lifecycle funds have a rather simplistic concept which, in and of itself, 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 grows older.  The funds have names that include a desired year of retirement in five-year increments.  The three dominant players, controlling almost 75% of all assets into these types of funds, are Fidelity Freedom Funds, T. Rowe Price Retirement Funds, and Vanguard Target Retirement Funds.

The concept of target date funds originated with Barclays Global Investors’ Life Path Portfolios in 1993.  Use of these funds began to rapidly accelerate immediately following passage of the Pension Protection Act of 2006, when target date funds received government approval to be automatically selected as the default choice for new contributions into employee tax-deferred retirement plans.  A potential advantage of this change is that it can keep retirement plan participants fully invested and focused on the long-term growth of retirement savings.

Previously undirected deposits were made into cash or money market funds unless specific investment instructions from the account holder were on file.  Financial industry consultants Cerulli & Associates Inc. estimate that target date funds currently make up 20% of all company retirement plan assets and 42% of new deposits into retirement plans.  Both of these percentages are expected to grow by at least 50% over the next five years.

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 dynamics and design of their specific fund.

Glide Path

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.  There are also design choices made by the TDF fund for the glide path to be “to” or “through” the targeted date of retirement.  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 several drawbacks of target date funds that should be noted.  For example, there are no standardized industry definitions for the design of the glide paths.  Another disadvantage is that each TDF makes the assumption that all investors have same financial needs and risk tolerance.  A third potential issue is that many funds are not direct investments, but comprised of a collection of proprietary, in-house, fund-of funds mutual funds.  The proprietary nature of the funds opens up the possibility of higher fees or poor performance from some of the underlying holdings.  Lack of transparency regarding the total cost of these funds could also be an issue.  The most significant problem with target date funds, however, is the lack of protection during times of adverse 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 lost 1/4th of the value of his entire account.

Here are a few points to consider when evaluating target date funds:

  1. Does the fund follow a “to” or a “through” retirement date glide path?
  2. When does the glide path reach the landing point and level-off?
  3. What are the past history of the fund and the experience of fund management?
  4. What is the trade-off between investment risk and the risk of outliving assets?
  5. Are total fund fees transparent and not excessive?
  6. Is the fund manager allowed to deviate from the glide path explained in the prospectus to make tactical (market-timing) adjustments?

Summary

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 BEFORE the inevitable periodic stock market correction occurs.  All investors should have at least some allocation to stocks to keep up with inflation and help to protect against the risk of out-living assets over a long life expectancy.  On a final note, remember that lifecycle target date funds are long-term investments and not a suitable place to park funds needed to meet short or intermediate-term goals.  Use of these funds does not guarantee that the individual investor will be saving enough for retirement.

Christopher Parr, CFP® is president of Columbia-based Parr Financial Solutions Inc., a fee-only wealth management firm.  His articles have appeared in the Business Monthly since 1997.  He can be reached at 410-740-9011 or www.ParrFinancialSolutions.com.

This article was written for the June, 2014 issue of The Business Monthly.