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Target-Date Mutual Funds: A Step in the Right Direction, But Far From Ideal

In a recent installment of our Articles on Wealth Management Topics entitled Investors and Retirees Need Financial Guidance ... And They're Getting Some, I mentioned that target-date mutual funds (TDF's) have become much more popular as investment options in retirement plans since the passing of the Pension Protection Act, but noted that "... target-date funds are certainly not a panacea ..."  Why not?  What are the drawbacks of being invested in TDF's?

Target-date mutual funds have been attracting more and more assets during the last decade, primarily as a result of their burgeoning use in 401k and 403b plans.  Plan sponsors and participants alike are drawn to the simplicity of TDF's, but as is often the case, the easy solution is not the best one.

The weaknesses of target-date funds stem from three words: lack of customization.  All investors in a given vintage of TDF - say the year 2030 investment option as an example - are treated as having the same risk tolerance and investment time horizon.

But different investors may react very differently to the returns generated by a given 2030 target-date fund. Investors with higher-than-average risk tolerances may become impatient with the comparatively pedestrian returns that will be generated by these mutual funds during equity bull markets.  And investors with lower-than-average risk tolerances may become disenchanted when these funds exhibit more downside risk than these investors are equipped to handle during the inevitable bear market.  Either way, because the asset allocation of the fund isn't customized to an individual's risk appetite, the danger is that investors bail out of their TDF's at exactly the wrong time .

With respect to investment time horizon, TDF's are designed through their asset allocations to become steadily more conservative as retirement date approaches. Typically this means heavier bond and cash weightings at the expense of stock weightings.

But different retirees have different needs for income from their investment accounts at retirement.  For instance, I have several clients who require no investment income at retirement because their Social Security and pension benefits combined will offset their living expenses.  Other retirees may be able to rely on rental income or on a spouse's earned income rather than on cash flow from their investment accounts.

For investors like this, a TDF's transitions to more conservative asset allocations as time passes will be unnecessary.  And to make matters worse in the current market environment, especially for investors in near-dated target-date funds (2020 and 2025), these unnecessary re-allocations will be towards bonds and cash at a time when those asset classes hold very little promise.

The moral of the story? Target-date funds may be off the mark when your individual financial circumstances are considered.