The T. Rowe Price Retirement 2020 Fund has 60% in stocks when it hits its target date, contained in six to eight T. Rowe Price funds. The stock positions are gradually reduced. The expense ratio is 69 basis points.
The Vanguard Target Retirement 2020 Fund invests in seven Vanguard index funds. At the target date, the fund will have 50% in stocks then gradually reduce its positions. The expenses run just 20 basis points.
There is no free lunch with these portfolios. If research on these funds is any indication, financial advisors themselves must make sure that the risk level of the mutual fund matches a client's tolerance for risk based on his or her investment time horizon.
An April 2008 working paper by Francisco J. Gomes, finance professor at the London School of Business, found that target date or life cycle funds that do not match the risk tolerance and investment horizon of investors may not deliver as much money as a retiree expects. The paper, Optimal Life-Cycle With Flexible Labor Supply: A Welfare Analysis of Life-Cycle Funds, is available at the National Bureau of Economic Research (http://www.nber.org/papers/w13966).
Other research, published in the 2007 Financial Services Review by Harold J. Schleff, economics professor at Lewis & Clark College, found that investors would do just as well investing regularly and passively with a mix of stocks and bonds during the accumulation stage.
The $64,000 question: What should clients do with all the money piling into target funds when they finally hit their target dates?
Garth Bernard, actuary and partner with Retirement Income Solutions Enterprise Inc. in Roswell, Ga., says most people often cash out. So it is important for a financial advisor to assist clients in setting up a retirement income portfolio based on cash flow needs and longevity risk. The advisor can analyze a retiree's source and use of funds and cash flow to segment their investments.
"People tend to cash out their target-date funds at the target date," Bernard says. "Then they have to make other investments that correspond to their cash-flow needs during retirement."
Bernard says that an advisor should seek solutions by looking at a number of investment options. Some money can be invested in high-dividend-paying stocks, corporate bonds, REITs, preferred stocks and mutual funds for both income and some growth. He also suggests investing part of a target date fund's proceeds in an immediate annuity to meet a retiree's fixed costs, such as food, clothing, shelter and medical needs for life. A financial advisor could ladder immediate annuities, so that the income stream keeps pace with inflation. The rest of the investment may be put in stocks and other securities for growth to keep pace with inflation.