Julie Jason:
Use target-date funds for your 401(k).
In last week’s column, I promised to continue our conversation about target-date funds, which some believe can help employees manage their 401(k) investments.
As professor Jamie Hopkins, of The American College of Financial Services, explains, “There are real benefits of targetdate funds because they can automate part of the investment strategy for savers.” Hopkins is the author of “Rewirement: Rewiring the Way You Think About Retirement!”
One can pick a target-date fund that “targets” the year of your retirement. For example, “XYZ Target Date Fund 2040” invests along a “glide path” that changes allocations for stocks and bonds over time going toward 2040.
Essentially, a glide path flows from “accumulation,” when the goal is to grow capital, to “transition” which is the period in which the manager increases bond holdings and starts to lower stock allocations. The last phase is “distribution,” during which time bond allocations are the highest.
The prospectus for the fund will tell you about the logic behind the fund’s allocation changes.
Here is an example, quoting from a fund’s prospectus: The fund “is intended for investors seeking professional management of a comprehensive asset allocation strategy for retirement savings. The fund is managed for shareholders that plan to retire or begin withdrawing assets around the year 2020, the fund’s target year.”
The target year is “self-elected,” meaning that you, the investor, decide which fund to choose in the sponsor’s targetdate fund offering.
Target-date funds typically have series that vary their asset allocation (stocks versus bonds) depending on the number of years left until the “self-elected” year of retirement. For example, this fund family has eight offerings that an investor would select based on the year of retirement: 2020, 2025, 2030, 2035, 2040, 2045, 2050 and 2055. A ninth offering is an “income fund.”
Each of the target-date funds follows a glide path methodology based on this principle: “The fund’s allocation is intended to meaningfully reduce risk and increasingly focus on preservation of capital as the target retirement date of the fund nears.”
How does the manager make glide path decisions? In this case, the fund family “uses a four-step approach consisting of 1) developing and re- evaluating a longterm asset allocation “glide path”; 2) performing tactical allocation adjustments around the glide path; 3) developing a series of relative value strategies designed to add value beyond the target allocation; and 4) utilizing hedging techniques to manage risks.”
Managing risks is important, but not absolute. This warning puts things in perspective: “There is no guarantee that the fund will provide adequate income at and through your retirement.”
Investors do need to accept there are risks in any investment offering, no matter how well designed. Further, the distribution phase after retirement needs to be well understood (more on that next week). And, in addition, there is the element of investor behavior: Target-date funds might be “risky because they function as a ‘set it and forget it’ strategy, which can cause some investors to disengage from the saving and investing process,” according to Hopkins.
However, target-date funds seem to be a better solution than having an individual manage his or her own investment allocation strategy over time,” Hopkins said, adding that “target-date funds perform far better on average than individual investors that manage their own investments.”
Why do individuals underperform? “Individual investors that try to manage their own investments tend to suffer from a number of behavioral biases that lead to poor investment performance,” said Hopkins. “Targetdate funds are uniquely designed to help offset some of these harmful investor behavioral biases by reallocating the individual’s investments over time to become more and more conservative.”
Target-date funds may help certain individuals, but they are not for everyone. Next week, we’ll compare some funds and consider research tools.