Think you can plunk down a client's money on any target date fund as a low-risk way to accumulate retirement savings?
Think again.
Target date funds use asset allocation and rebalancing strategies. Often, they aid an asset-holder's transition from a strategy of capital growth to one of capital preservation by gradually shifting funds from stocks to fixed-income instruments such as bonds and cash.
There are 300 target date funds, which together hold assets of almost $200 billion, according to the Investment Company Institute. Not all are alike. The majority have not been around for even three years, according to Morningstar Inc., Chicago. So they have no long-term track records.
Often, they fall into three groups, named for the date ranges in which they will likely reach fruition: "2000-2014," "2015-2029" and "2030-plus." The portfolio manager changes the mix of stocks, bonds, cash and other assets faster or slower as the fund approaches its target date, making changes according to the fund's "glide path." Typically, this path continues after the funds hit their target dates, as the allocation of stocks continues to decline during the investor's retirement years.
Thanks to the Pension Protection Act of 2006, target date funds have become a default option in 401(k) and 403(b) defined contribution plans. Many plan sponsors want investment companies to customize them for their plans by setting up "collective investment trusts"-products that are similar to mutual funds but only offered through qualified retirement plans. With such tailor-made trusts, investment companies can lower costs and offer a wider range of alternative investments in real estate, REITs and emerging-market securities. These newly formed collective trusts use more sophisticated asset allocation and glide-path strategies.
"Generally [target date funds] are living up to expectations," says Chris Lyon, partner with the employee benefits investment consulting firm Rocation in Norwalk, Conn. "There are a lot of new products available, so it is difficult to evaluate them. But the funds are a lot better investment for the typical plan participant."
Unfortunately, plan participants have no option when it comes to selecting the investment company that runs the target date funds in the plan. Apart from 401(k)s and 403(b)s, Lyon says that financial advisors also can add value to client services by helping them select the right target date fund for IRAs, Roth IRAs, IRA rollovers, SEPs and SIMPLE plans.
But they must narrow the field from a vast array of options. Variables that must be considered include: the track record of the overall fund group, the stability of management, the method of allocating assets, a fund's expenses and the characteristics of the individual mutual funds that make up the target date fund's portfolio.
"Their asset allocations differ as well as the glide paths," says Morningstar analyst Greg Carlson. "Some funds are more aggressive early on, while others may be more aggressive in later years."
Carlson says that funds use similar methods to allocate assets. They consider the mean variance approach, based on the correlation among investments, expected rates of return, economic trends and stock and bond fundamentals.