These popular retirement funds may give false sense of security
Wednesday August 8, 1:34 pm ET
By Robert Powell
What's wrong with the nation's fastest growing retirement funds?
BOSTON (MarketWatch) - The fact that target-date and lifestyle mutual funds have become all the rage among retirement savers is undeniable. Whether or not that's entirely good news is debatable.
Assets in these all-in-one, set-it-and-forget-it funds grew by 50% in 2006 to almost $303 billion, and that's after growing 57% in 2005, according to the Investment Company Institute. Nearly one-quarter of the 401(k) account balances of recently hired workers in their 20s are invested in such funds, according to a recent ICI report. See related story.
Lifecycle or target-date funds rebalance over time as the investor's retirement date approaches. They're named for the year of retirement, such as "2025" or "2050." Lifestyle or target-risk funds, meanwhile, are designed to sync up with an investor's risk tolerance, and they're labeled "aggressive" or "conservative," for instance.
There are many and good reasons why these funds have become so popular in recent years. In essence, they take the hassle out of trying to figure out how to allocate assets, which funds to buy and sell, and when to rebalance a portfolio.
These funds are silver bullets for many forlorn 401(k) and IRA investors. But while they seem like a magical solution, they are not without risks. Indeed, experts say investors should take heed of the following precautions and warnings before buying (or even after buying) target-date or target-risk funds.
A one-ingredient recipe
The biggest problem with these funds? They consider just one of the many ingredients that typically go into the recipe that makes up an investor's portfolio.
In the case of target-date funds, the one ingredient added is time horizon. With target-risk funds, the one ingredient is risk tolerance.
By contrast, financial advisers typically examine a variety of factors when building an investor's portfolio, including a person's age, income, other tax-deferred investment accounts, other taxable accounts, and investment objectives, to name just a few.
"You really need to look at everything," Susan Black, director of financial planning at eMoney Advisor, a unit of Commerce Bancorp, said in an interview. "These funds are for those who want to take the easy way out. But the reality is that people really need holistic planning."
To be fair, Black and others do say these funds are better than nothing and certainly are better than extreme investing - investing either too aggressively or too conservatively. But in the main, these funds are best suited to novice or young investors who have little or no assets outside of their 401(k) plan and who are willing to invest all or nearly all of their 401(k) money into these funds.
Fund overlap could mean more work
Other investors, however, have many issues to deal with when it comes to investing in target funds. For instance, some of the underlying investments within target-date or target-risk funds will likely overlap or duplicate the funds investors already have in other taxable and retirement accounts. At best, overlapping investments is unnecessary; at worst, it's imprudent.
What's more, investors will likely have to re-jigger the investments they have in their other retirement and taxable accounts to get their overall asset allocation just so.
Consider, for instance, how typical investors have 40% of their money in retirement accounts and 60% in taxable accounts. Now consider how a typical adviser often suggests that an investor put 60% of his money in stocks (in taxable accounts) and 40% in bonds (in retirement accounts). This means the investor has to go through the process of calculating how much of his target fund is invested in stocks and then calculate how much more he should invest in stocks in other accounts.
Let's say the average investor has $66,650 in a 401(k), all of which (for purposes of illustration) is in a target-date fund, and $165,000 sitting in other accounts. This means the investor should have roughly $140,000 invested in stocks and the rest in bonds. Now let's say the target-date fund in the 401(k) has roughly $40,000 invested in stocks.
That means our hypothetical investor would need to invest another $100,000 in stocks in other accounts, making sure to avoid any overlap with the target-date fund. Suffice to say, buying target-date and target-risk funds could turn out to be just as much work as building a portfolio on one's own.
No two investors are the same
Another issue is that these funds presume everyone has the same retirement age or risk tolerance without regard for age or income or investment goals. And that's especially worth noting since target-date and target-risk funds will likely become a qualified default investment alternative (QDIA) inside 401(k) plans in the not-too-distant future.
"As far as QDIA, I think the big issue will be suitability," Louis Harvey, president of Dalbar Inc., a Boston-based financial-services consulting firm, wrote in an email. "Should the CEO that is 45-years-old have the same investment as his or her secretary because they are the same age?"
According to Harvey and others, most of today's QDIAs are targeted for the younger employee with small balances, and are less suitable for those looking at retirement. "The older and wealthier employees are almost always better of with a fiduciary adviser who will do serious pre-retirement planning," he said.
Same name, different asset allocations
There are other precautions as well. A rose by any other name might still be a rose. But not so with target-date funds. Indeed, target-date funds featuring the same date in their name often have very different asset allocations.
One firm's 2025 fund might invest 60% of its assets in stocks while another firm's offering might invest 75% in stocks. And that means funds with the same target date in their name will likely have very different risk-return profiles. A rose by any other name is really a black pine in the case of target-date and target-risk funds.
So what does that mean for investors seeking the lazy man's (or woman's) solution? Those investors still have to break a sweat.
"With target-date funds you should do more than simply find the date that matches your age at 65, for example, and buy that fund," Christine Fahlund, vice president and senior financial planner at T. Rowe Price Group Inc., said in an email.
"You need to know whether the asset allocation of that fund is consistent with your investment risk tolerance, now and in future years. If it is currently too high or too low in equities for your taste, it is important that you realize that and find a target date fund that matches your personal needs -- both now and as it 'glides' to other asset allocations in the future," Fahlund said.
Why is it important for you to get this second step right? "Because you don't want to wake up later after you've invested in the fund and wonder why its value has dropped precipitously over the past year because of a relatively high concentration in equities or why your balance hasn't grown the way you had expected it would because of its relatively heavy investment in bonds," Fahlund said.
Besides having different asset allocation, these funds often have very different "glide paths." In general, all these funds are designed to become more conservative over time as they approach the fund's target or maturity date.
The funds generally do this by reducing the percent invested in stocks and increasing the percent invested in fixed-income securities. How quickly or slowly these funds reduce the percent invested in stocks over time is called the glide path. Not surprisingly, glide paths vary from one mutual-fund firm to the next.
Forget me ... not!
Another thing to watch out for is the concept of investing and forgetting about it, said Sheryl Garrett, author of "Garrett's Guide to Financial Planning," in an email.
"Nobody should invest in anything and forget about it," she said. "These target strategies do transfer the re-allocation work to the fund manager; but that re-allocation will not include how the individual's other investments are positioned."
Says Garrett: "Target funds can be a very good option for the individual investor with little guidance or knowledge about investing."
All others should take heed: Though sold as and perceived to be a one-size-fits-all solution, target-date and target-risk funds are not entirely what they seem.
Says Fahlund: "Do your homework before you make your selection, and you'll be a much happier investor over the long term."http://biz.yahoo.com/cbsm/070808/202e88acf7964939a56b9d8d8587849b.html?.v=1&.pf=retirement