3 Things You Need to Know About Target Funds

June 23, 2014 12:00 am

Christine H. Canapari, ChFC®

Senior Financial Advisor & Manager of Client Services

Target date funds are a relatively new investment option.  They are basically a mutual fund which links to a specified retirement date of your choice, and their allocation is comprised of varying percentages of equities, fixed income and cash, depending on your time horizon.  These funds came about around 1994 but grew in popularity more recently with the passing of the Pension Protection Act of 2006 (PPA).  One of the elements that the PPA addressed was putting more responsibility on employers and plan sponsors for providing broader investment options in their employee’s 401(k)s.  Previous to the PPA, a participant who didn’t choose an allocation would normally be placed in a money market or similar type account until they made changes to the allocation.  While money market and fixed accounts are considered to be quite safe, it is unlikely that by only investing in cash type holdings that your investments will be able to adequately grow to a sufficient amount to fund your retirement.  So target date funds became the default option in many retirement plans for participant’s initial contributions because they are made up of holdings that have traditionally provided more growth potential.  Although target date funds seem like a quick and easy solution and may be an appropriate option for some, investors will want to analyze the fund that they are choosing for proper allocation, suitable risk and retirement strategy practices that the particular target date fund employs.

All Target Date Funds Are Not Created Equal
Just about every mutual fund company offers their version of target date funds.  There are a variety of names for these funds such as “Lifestyle”, “Lifecycle”, and “LifePath” and many more, but the key component in each is the retirement year attached to it.  So for example, if I were a 40-year-old investor hoping to retire at age 65, in theory I would choose a 2040 fund.  The fund manager will rebalance the fund each year using the retirement date as the goal and make adjustments to equity and fixed income holdings accordingly.  However, just because target date funds share the same retirement date does not mean that they have the same underlying allocation.  Two target funds with the same retirement date from different fund companies may have very different amounts of associated risk.  That alone is not a reason not to use target date funds if you are unable to manage your own investments or to have your portfolio professionally managed by a financial advisor.  It is reason, however, to investigate exactly what you are investing in.  Read the data on the funds composition and review all fund literature regularly to keep track of any changes to the allocation.  Contact the fund company if you have additional questions that you are not able to ascertain in your research.  If the fund closest to your retirement date is not exactly what you are looking for, check out the funds within five to ten year ranges before and after your date.   It is not imperative that you use the fund dated nearest to your expected retirement date if you find the allocation of another retirement year’s fund is more appropriately suited to your risk tolerance.

Your Personal Risk Tolerance Is Not Being Considered
It would be simple if your age and retirement date were the only factors you needed to consider when choosing your investments.  Unfortunately for most investors, that is not the usually the case.  How you personally feel about risk and volatility in your investments should also be taken into account when allocating your portfolio.  Even though two people may be retiring in the same year doesn’t mean that they have the same feelings about how much risk they can handle.  By using risk assessment tools or working with your advisor, you can determine how comfortable you are with volatility in your accounts.  Situations can vary greatly from one investor to another.  One investor, who will be receiving a pension and not does require much supplemental income, may choose to invest more conservatively than one relying solely on their portfolio to provide retirement income.  Perhaps another investor’s objective is to leave these particular assets to their much younger heirs, so he or she may choose to invest very aggressively and use the heir’s time horizon instead of their own.   Another aspect these funds don’t fully address is current market and economic conditions.  Adhering to a specified equity allocation can be challenging in times such as 2008 when many of these target funds even with a 2010 retirement date suffered significant losses.

What Happens at my Specified Retirement Date?
It is also important to understand what your fund’s allocation will do when it reaches the stated retirement date.  Target date funds are either described as “to” or “through” retirement strategies.  The “to” funds will reach their most conservative point at the target date and the allocation will generally remain the same thereafter, while the “through” will continue to make adjustments even after the retirement date has occurred.  In today’s world of increased longevity, a “through” strategy is probably more effective since retirement periods of 30 or 35 years are increasingly common.
For some investors, target funds may be the answer to wanting a managed approach to their investments while not taking a very active role.  However, investors must be aware that there is a bit more research involved in owning these funds and they are not entirely “set it and forget it”.  Picking appropriate investments is challenging work for all investors, so if you choose to use these funds, be sure to do your research and have awareness of your risk tolerance.  That should make it easier to find a suitable choice to help you reach your goals.

Chrissy Canapari serves as Financial Advisor and Manager of Client Services at StrategicPoint Investment Advisors in Providence and East Greenwich. You can e-mail her at ccanapari@strategicpoint.com.

The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Chrissy’s opinions and comments expressed on this site are her own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.