As part of our ongoing financial planning work, we assist our clients by recommending an allocation for their retirement plan accounts (401k, 403b, etc.) that cannot be directly managed by us because of plan regulations. We analyze the fund options within the plan and recommend an allocation to ensure the asset breakdown of the account is in line with their managed accounts and the optimal investment strategy advised by the client’s financial plan.
We recently completed this analysis and annual recommendation for a client who later asked us why we avoided all the target-date funds at his disposal. We have always been wary of target-date funds, primarily due to the lack of individual customization. Every person invested in the same target-date fund is assumed to carry the same risk tolerance, return objectives and time horizon. This, of course, will never be the case.
An August 31, 2015 article issued by CNBC, Some Target-Date Funds Miss in the Market Turmoil, details another concern we have with this type of fund. Each target-date fund (even those associated with the same retirement date) has a different makeup of bonds and stocks that is governed by the fund’s glide path. From that CNBC article: “Much of a target-date fund’s performance is determined by the fund’s ‘glide path’. That’s the formula a target-date fund uses to determine its mix of assets over time. All target-date funds get more conservative over time, shifting out of stocks and buying more bonds as they approach the target date.” Some funds have a glide path that ends, with no future allocation changes, at the retirement date, and others glide right past it and continue to get more conservative for years following. If you are invested in a target-date fund, it is important to understand the current allocation of the fund and the ultimate path it will take.
A fund’s unique glide path will determine exactly how conservative the fund will be upon reaching the target-date year. This makes for impactful allocation and performance differences between funds that one might otherwise misperceive to be quite similar. This concept is especially obvious during times of stock market volatility. “For example, take two target-date funds designed for investors who retire this year: The Fidelity Freedom 2015 fund, which has more than 43 percent of its holdings in bonds and cash, lost 2.5 percent for the month through August 27, while the Wells Fargo Advantage Dow Jones Target 2015 fund, which has a nearly 71 percent stake in bonds and cash, lost only 0.87 percent over the same period.”
The Fidelity Freedom 2015 fund has 28% more exposure to equities than Dow Jones Target 2015 and, therefore, it experienced a more dramatic drop during the recent market correction than its counterpart. Losing 2.5% in less than a month can be devastating to someone who plans to retire this year and needs their retirement account to fund their lifestyle. If an individual has other sources of income, it may be less painful, but target-date funds have put the onus on the investor, or perhaps the investor’s Certified Financial Planner™, to know the fund’s equity exposure and whether that exposure makes sense for his or her retirement goals.
In summary, we prefer to customize retirement accounts to meet our client’s specific needs and reassess the appropriateness of the allocation on an annual basis. A person’s financial plan should be the investment guide rather than a fund family’s preconceived notion about how universally conservative a retiree should be.