Target-Date Funds I

Target-Date Funds

Target-Date funds have a lot to offer. They are supposed to be a “single decision” fund and completely maintenance free. Once you selected your target retirement date, then just choose the Target-Date fund closest to that date and you are set until retirement. Life-time income funds are the complementary “single decision” funds that you use in retirement. These funds not only adjust the asset mix from more aggressive to more conservative mix as you approach retirement, but also will do rebalancing as required in case some asset class due to over/under-performance shifted the allocation away from the appropriate one. Dow Jones even developed a set of indexes that may be useful as benchmarks for these funds (CMAC)
There is no question that Target-Date funds are appropriate for many individuals. For example for a young person just starting out in the workforce and wants to start saving toward retirement. It is also appropriate for individuals who want a no/low-maintenance retirement portfolio.
But there are a series of potential problems, especially if one is not careful with implementation details. Here is a list of some of the potential issues:
• Not all Target-Date funds are identical. So a Target 2030 fund from Vanguard will have a different asset mix that one from TIAA-CREF. Specifically, different overall stock component and different international asset component • At any given age or even at point of retirement, not all individuals have the same risk tolerance. • The ongoing management cost of funds has a significant disparity. Vanguard charges 0.25% whereas others(?) may charge as much as 1+%. Over a 30-40 year pre-/post-retirement period the higher fee can cause a great deal of damage to the value of the asset. The Target-Date funds available in Canada are even more expensive, causing even more damage. • Still on the subject of cost, some funds charge two layers of fees, one for the funds comprising the underlying asset classes of the Target-Date fund and another top layer to manage the Target-Date fund itself • The fund implementation can be different as well. As building blocks to construct the Target-Date funds, some use passive index funds, others actively managed funds and still others restrict you to their own in-house funds. • Target-Date funds cause complication when mixed with other funds. A gross mis-application would be to build a portfolio composed of Target 10, 20 and 30 funds at 33% each, just because the plan sponsor offered those funds. Less obvious challenge would be to mix with other funds while the Target-Date fund asset mix is changing with time. • Complication result in how to use a Target-Date fund with a tax sheltered account, where normally one would like to place the fixed income portion of the overall portfolio. • Unavailability of Target-Date ETFs
For some U.S. based investors, the Target-Date funds can still be a good solution, if one is careful to avoid the above pitfalls. For example go with the low cost families, or if you want to accept more risk, choose a target date that is five or ten years after your retirement. If you also want more international exposure then offered in the selected fund, then add an extra international ETF. They are good when you are prepared to go with what is offered and accept the limitations as a trade-off for maintenance free implementation. The Canadian offerings are too expensive at this time to be able to recommend.
We will look separately at a model for implementing Target-Date portfolio based on asset classes represented by available index ETFs. If executed well, we can eat our cake and have it too. That is we can solve the cost, the mix with other funds, and place the fixed income component in a tax-sheltered account. The implementation specifics will be different for U.S. and Canadian investors.
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