Many of us use “all-in-one” products. The universal remote control is probably the most ubiquitous all-in-one device, although for many of us it is a source of constant confusion because of its dozens of buttons. Then there’s the all-in-one printer, which can also scan and fax documents. If you have limited living space you may have purchased an all-in-one washer/dryer. The investment world has its own all-in-one product, called a target-date or life cycle fund. Is the target-date fund a panacea for investors? What are the trade-offs? Who should invest in a target-date fund? This week’s column is dedicated to exploring the investment world’s all-in-one product.
Last year 30 percent of all new mutual fund contributions went into target-date funds, which now represent over $700 billion in assets. Target-date funds are portfolios of mutual funds or exchange-traded funds designed to provide investors with a long-term comprehensive investment solution for someone trying to save for retirement or college. Years before retirement or a student’s freshman year, target-funds are usually heavily invested in equities, and then as retirement or college approaches, the asset allocation begins to become more and more conservative and income-oriented.
Whether you are considering investment options for your 401(k) retirement plan, your IRA, or the state’s 529-college savings program, you are likely to find a series of target-date products. Just like your television remote, which controls your cable, DVD, and DVR, a target fund promises to control everything. Rather than constructing an asset allocation of stocks and bonds and then having to select half dozen or more funds, a target-date fund offers a simple solution. All you have to do is estimate when you’ll retire and select a fund that corresponds with that date. In this column, I’ll focus on retirement, although college savings funds work the same way.
For example, if you are thirty years old and plan to retire at age 65, you merely have to select a 2050 target-date fund and systematically put your retirement savings into that fund. Most major sponsors offer target funds in five-year increments (e.g., 2020, 2025, 2030, etc.) Having been heavily exposed to the stock market for the next twenty years, your balance should grow substantially. In the years before your anticipated retirement, the fund will begin to reduce risk and start to build up income. Most funds will continue to offer a conservative mix of assets for 25 to 30 years after the estimated retirement date. Borrowing from aviation, this process is known as the glide path.
Sounds great, doesn’t it? While target-date funds can be a reasonable solution for some investors, you should always be wary of one-size-fits-all solutions to complex problems. The manager of a target-date fund doesn’t know you. He doesn’t know your tolerance for risk. He doesn’t know if the target fund is the sole source of your retirement savings or just one piece of the puzzle. As a result, he’s going to be managing the asset allocation and selection of the underlying investments for some hypothetical average investor.
If you study the hundreds of target-date offerings now available to investors, you’ll see that there’s little agreement on what the average investor’s portfolio should look like. One manager will be more heavily weighted to equities, another will shade the equity allocation to small cap or emerging market stocks, and yet another will dabble in alternative investments. Moreover, different managers have different ideas about how actively they should be shifting around the target fund’s assets either to anticipate market movements or react to the performance of the underlying mutual funds. Some managers use active mutual funds within the target-date fund, while others rely on index funds, and yet others mix active and passive approaches.
Managers don’t agree on the glide path either. Some will begin paring back equities sooner as retirement approaches, while others will wait until shortly before the target date to rapidly reign in the risk in the portfolio. Much like approaching an airport runway, I tend to favor the gradual approach. Since no one knows when the stock market will take one of its periodic dives, I prefer target funds to jettison some of their equity exposure years before the retirement date. At the same time, I don’t want them to become too conservative because some portion of the target portfolio needs to grow even after retirement.
The right fit
Of course, all these differing approaches will also affect the fees you pay. Clearly, index or passive approaches are far less expensive than active ones. However even among actively managed target-date funds, fees can vary a great deal. As with most every investments, it’s usually wise to keep expenses as low as possible. All other things being equal, lower fees tend to result in higher returns over the long-term.
Many financial planners are highly critical of the target-date fund’s one-size fits all approach. Moreover, they rightfully point out that target-date funds tend to commit the investor to a single fund family. For example, Vanguard, Fidelity, and T. Rowe, the three largest managers of these products with 71 percent of the market, only use their funds in their target-date offerings. There are some 401(k) and 529 plans that have target funds with multiple fund families. This flexibility tends to come with higher costs and doesn’t appear to have a significant affect on long-term performance.
For all the differences between sundry providers and the problems of using an untailored product, I think target-date funds have value for certain investors. As Morningstar points out in its recent report, “2015 Target-Date Fund Landscape, these products seem to be getting the job done for their investors despite the variations in approaches, fees, and performance.
For those investors with substantial assets, there’s no reason to consider a target fund. Whether you use a financial advisor, broker, money manager, or do-it-yourself, those with substantial assets ought to have an asset allocation and glide path that is customized to their tolerance for risk and the value of all the other assets on their personal balance sheet. How do you know if you have substantial assets? If brokers or financial advisors are willing to provide you with a dedicated professional along with a team to help develop a detailed financial plan, you probably have substantial assets. If brokers or financial advisors furnish you with an 800-number or a website as your primary source of contact, you don’t make the cut – which is most of us.
Simple is best
So who should consider a target fund? Here’s a quick and counter-intuitive test for those of you whose accounts aren’t being madly pursued by the wealth management industry. Are you prepared to read some or all of Morningstar’s 84-page report? If you are prepared to study the report or relish the idea of wallowing around the prospectus and annual reports of target-date funds, then you are not a candidate for this product. At first blush this probably doesn’t make much sense to you. The point is that if you’re going to dig deeply into the underlying mutual funds, the precise construction of the glide path, and the tactical and strategic objectives of a target-date fund, then you might as well go ahead and construct your own portfolio of mutual funds, ETFs, or individual securities. Clearly, you are prepared to do the work.
Target funds are for those investors with relatively small investment balances, who have better things to do than peruse the fine points of a prospectus. For those folks, simple is best. Stick to index-driven, low fee target funds. If your 401(k) (or state 529 educational savings plan) doesn’t offer index based target-date funds, those funds may still be your best option. Although an actively managed target fund will drive up your expenses, it is better to have a more expensive diversified investment portfolio than to blindly pick a bunch of mutual funds or keep your 401(k) sitting in too much cash. Target-date funds aren’t perfect. Then again, a highly customized financial plan isn’t perfect either.
Andrew Silton’s Meditations on Money columns can be found twice a month in The N&O’s Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/