In today’s economic environment, everyone is looking for a better and easier way to save for retirement; with no shortage of people on Wall Street eager to develop new financial products to help consumers find those ways, target-date funds are the latest inventions that have become all the rage. Though target date funds are not new, their recent growth in investor appeal is cause for greater scrutiny. At face value, they offer an easy way to save for retirement without a lot of effort. The idea is simple enough; investors put money into a fund that closely matches their retirement date; the fund starts off aggressive and gradually becomes more conservative as the investor nears retirement age. This decision seems like a no-brainer to many who want to put their investments on auto-pilot. Unfortunately, target date funds are not suitable for everyone.
Risk Tolerance
The main disadvantage to target-date funds is that they assume everyone has the same risk tolerance. Risk tolerance is a combination of an individual’s ability and willingness to take risk. One’s ability to take risk is driven primarily by their wealth. A person with $100 million who spends $100,000 a year clearly has a high ability to take risk. Willingness to take risk, however, is very subjective. That same person may be less inclined to take risk if they have previously lost money in the market. For this reason, the same fund may not be suitable for two different people who may be planning to retire in the same year and who may have conflicting risk tolerances. Proponents of these kinds of funds recommend adjusting the target date to bypass this shortcoming. For instance, a more risk-averse investor would purchase an earlier target date fund (because the fund will become conservative sooner) while the risk seeking investor would purchase a later target date fund. The problem with this approach is that choosing an earlier target date does not always ensure less risk (see apples to oranges below).
Best in Class
No mutual fund company is an expert in everything, and sponsors of target date funds are no exception. Target date funds diversify their holdings into stocks, bonds, and cash by acting as either a fund of funds manager or direct investing. Fund of funds managers diversify their holdings among stocks, bonds, and cash by investing in several other mutual funds to minimize risk. Target date funds that employ a fund of funds approach usually invest in their own family of funds. For example, if you look at the composition of any Fidelity, Vanguard, or T-Row Price target date funds, they all invest in their own mutual funds. These mutual fund companies cannot possibly have the best stock and bond mutual funds in every category. This approach also creates overlap because fund managers of the same mutual fund company tend to invest in the same investments which lead to the investor being charged twice for holding the same investment. While target-date funds that employ direct investing do not encounter this issue, these funds are the exception and not the norm.
Apples to Oranges
As with any investment, it is important to compare performance against a benchmark. For instance, someone invested in a large cap blend fund would compare its performance to the S&P 500. Target date funds are nearly impossible to compare to a benchmark or to one another because they do not neatly fall into any specific category. Fund managers have tremendous leeway in how they allocate their fund’s assets, and these ratios can change at any given time at the discretion of the manager. As a result, two different target-date funds with the same target date may have vastly different allocations on any given day, which makes benchmarking even more difficult. According to Morningstar, target-date funds with a 2010 retirement date have stock allocations of anywhere from 9.15 percent (DWS Target 2010 fund) to 65 percent (AllianceBernstein 2010 Retirement Strategy). And while common sense would lead us to believe that a 2010 target date fund should be fairly conservative because its investors are close to retirement, the range of losses among funds is sizable. The DWS Target 2010 fund lost 3.6 percent in 2008 while the Oppenheimer Transition 2010 N fund lost a staggering 41.5 percent in the same period. According to a recent Wall Street Journal article date June 19, 2009, Morningstar found that funds with target dates between 2011 and 2015 lost 28 percent. There is no shortage of articles written about the poor performance of target-date funds for people close to or near retirement.
Bottom Line
Individuals interested in saving for retirement should develop an asset allocation that is appropriate for their objectives and their risk tolerance. No one should begin retirement assuming their portfolio is safe, only to find out later that their assets were in invested risky funds and they have lost 20 percent. Investors shouldn’t have their retirement savings exposed to undue risk so close to retirement.
Ara Oghoorian is the president and founder of ACap Asset Management, Inc., a “Fee-Only” financial advisory and investment management firm located in Los Angeles, CA. Ara can be reached at aoghoorian@acapam.com.
Ara Oghoorian is the president and founder of ACap Asset Management, Inc., a “Fee-Only” financial advisory and investment management firm located in Los Angeles, CA. Ara has over 15 years of experience in the financial services industry. Prior to starting ACap, Ara worked for a wealth management firm in the Washington, DC area providing investment management, tax preparation/planning, financial planning, complex risk-management strategies, and financial advice to ultra high net worth individuals and institutional clients. Ara worked overseas for the US Department of the Treasury as an advisor to the Ministry of Finance and Economy in the Republic of Armenia. He also conducted work in the Republic of Georgia and the Republic of Latvia. He spent nine years at the Federal Reserve Bank of San Francisco auditing foreign and domestic banks and bank holding companies. He began his career at Wells Fargo Bank in Huntington Beach, CA. Ara earned a Bachelor of Science degree in finance from San Francisco State University and is a Commissioned Bank Examiner through the Federal Reserve Board of Governors. Ara holds the Series 65 license.
Ara can be reached at http://www.acapam.com, aoghoorian@acapam.com, or 310.779.7512
