Sometimes referred to as life-cycle funds, target retirement funds are promoted as “one investment choice for a lifetime.” At first glance, all target retirement funds look similar. They consist of a series of funds from the same fund family. Each fund is identified with a specific retirement year, such as 2020 or 2030. The fund managers allocate monies among stocks, bonds, and cash equivalents. As the target date approaches, the composition becomes more conservative, favoring bonds and cash. After the target date passes, most of these funds either merge into a retirement income fund or adopt an allocation that preserves purchasing power. The investor or advisor chooses a target close to the expected retirement date.
Three mutual fund companies manage > 80% of the money in this category: Fidelity, T. Rowe Price, and Vanguard. Target-date funds are particularly popular in retirement plans such as 401(k) plans. Part of this popularity is the reality that when employees are left to their own devices, picking funds and categories has resulted in dismal returns.
Some target-date funds begin with an allocation of 90% in stocks and 10% in bonds, moving to a 50/50 stock and bond split at the target date. Other funds may end up with 35% or less in equities. Once the target date is reached, some funds stop rebalancing; others continue to increase bond exposure for a number of years thereafter.
One Size Does Not Fit All
There are a number of problems with these funds. First, the financial objectives of people with a similar target date can be quite different. Someone age 65 in poor health may need more money for medical purposes. Another person age 65 may have plenty income, but needs something more growth-oriented so he or she may leave a larger inheritance.
Second, most of the fund companies offering these programs offer funds based on 10-year intervals instead of 5. Third, some fund groups increase the expense ratios for these “funds of funds.” Fourth, a number of the “sub” funds have track records < 10 years, making analysis somewhat limited. Fifth, some companies offer their best funds; others use a mix of some of their good and some not-so-good funds.
The Biggest Problem
The greatest concern about target retirement funds is their allocations are all over the board. The AIG SunAmerica High Water Mark fund has a target maturity of 2020 and a stock allocation of > 86%. The Russell LifePoints Strategy has the same target date of 2020, but its stock allocation is 50%. Similarly, the Seligman TargETFund has a 2025 date with > 94% allocated to stocks. Vanguard Target Retirement fund has the same 2025 target retirement date, but a stock allocation of < 57%.
Target Date 2031–2035 Funds [through 2011]
|
Year
|
Return
|
Year
|
Return
|
Year
|
Return
|
|
2011
|
-4%
|
2007
|
7%
|
2003
|
n/a
|
|
2010
|
14%
|
2006
|
14%
|
2002
|
n/a
|
|
2009
|
30%
|
2005
|
7%
|
5 years
|
-1.0%*
|
|
2008
|
-37%
|
2004
|
10.0%
|
10 years
|
n/a
|
*annualized
A number of life-cycle funds have increased their stock allocation from 80–90% for younger investors. One life-cycle fund for those just retiring has 55% in common stocks, 35% in fixed income, and 10% in REITs. The fund shifts to 25% in stocks, 10% REITs, and 65% in fixed income for those aged 80. The company’s research found a 1% higher annual return beginning at age 25 could “fund more than 10 extra years of retirement spending.”
Mutual fund life-cycle studies have concluded: (1) investors tend to pick more aggressive portfolios than their ages warrant; (2) when a couple retires, it should be expected at least one of them will reach their 90s; (3) the biggest risk to retirees is outliving their assets, and (4) life-cycle funds are likely to grow at a robust rate since the passage of the Pension Protection Act of 2006 (a default selection if the employee does not pick another option).
Some financial advisors are concerned the equity exposure for these funds is too high for those about to retire (e.g., some “2015 funds” have stock exposures as high as 63%). A University of Maryland finance professor recommends using three life-cycle funds. For example, someone retiring in 2015 could buy a 2015 fund to cover the first 10 years of retirement, a 2025 fund to pay for the years from ages 75 to 85, and a 2035 fund for the final years.
Opinions vary as to how much a target date fund should have in equities. Some funds with a target retirement date of 2045 have ~ 95% of their assets in common stocks. There is also criticism as to what type of bonds should comprise the fixed-income portion. A few fund families feel the lowest risk asset should be TIPS rather than cash equivalents. What is receiving little press is what happens when an investor actually retires.
For example, someone born in 1919 retiring at age 65 would have experienced an annual stock return of just 2.2% above inflation while someone born in 1935 retiring in 2000 would have earned an inflation-adjusted 9.3% per year (through 2007). Using the same contributions, the person born in 1935 ended up with a lump sum four times > the worker born 16 years earlier. The annual income of the person born in 1919 came out to $9,630 a year vs. $38,580 for the worker born in 1935.
Expansion
Target retirement funds have also expanded the number of investment categories they invest in; emerging markets, REITs, TIPS, private equity, commodities, leveraged loans, and/or long-short funds are now being used by more frequently.
