Are You Planning to Use Target Date Funds in Retirement? 7 Key Considerations to Keep in Mind

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When reviewing a client’s 401(k) plan, I get pretty jazzed if I see a decent Target Date Fund (TDF) option within their investment lineup. I firmly believe that a TDF is one of the best default investment vehicles within most corporate retirement plans.

The way a TDF works is simple. You pick the fund that matches your approximate year of retirement. The money in that fund is invested based on a time horizon until that retirement year. For example, a 35-year-old investor today who intends on retiring in 30 years at age 65 may want to pick a fund with a target date year of around 2050. TDFs allow investors to seamlessly and prudently manage their retirement assets with one fund and minimal work. This is an adequate investment solution within 401(k) plans, where typically investors have limited investment choices and may be in the accumulation stage of retirement planning.

However, as one approaches the decumulation stage of retirement planning, it’s crucial to perform proper due diligence before incorporating TDFs into one’s plan. One must understand the differentiators between various TDFs available on the market and where they may come up short in helping retirees achieve their financial goals.

1)   Glide Path: Every TDF has what’s known as a glide path. The glide path represents the fund’s changing mix of investments, including stocks, bonds and cash, over time. When investors are further from retirement, they can afford to be more aggressive and the asset mix is more heavily weighted in stocks compared to bonds and cash. As the investor approaches his target retirement date, the fund “glides” to a more conservative allocation with more high quality bonds.

It’s important to know that the philosophy towards the appropriate glide path can vary based on the fund family that runs the TDF. Some glide paths maintain a higher stock allocation than others, even once entering retirement. The investor’s own personal situation would dictate whether this may be beneficial or too risky.

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For example, an individual retiring from full time work at 75, who is collecting the maximum amount of social security, will continue to consult part time, and has a spouse who plans to continue working for a few years, generally does not need his nest egg to grow rapidly. Therefore, he may not need to take much equity risk and a more conservative allocation may be warranted. The opposite may be true for someone who retirees early and needs to take more equity risk to ensure that their money lasts for longer during retirement. It’s imperative that the TDF’s glide path aligns with your personal situation.

2)   Cash Position: The level of cash allocation also varies based on the TDF. Every fund family views the allocation to cash within their asset mix differently. Additionally, some firms are compensated by paying little to no interest on an investor’s cash and keeping that return, even if very minimal, to themselves. It’s important for the investor to determine the cash allocation within their TDF to ensure it aligns with their specific needs.

If an investor is entering retirement at an early age, he may be very concerned about “sequence of returns” risk, which is the risk of experiencing several years of unfavorable returns at the start of retirement. This scenario of withdrawing one’s assets in the midst of a Bear Market can be financially devastating to an investor. However, if the TDF has a meaningful cash position, it can serve as a buffer to negative returns. Conversely, if the retiree has other income sources, and doesn’t need to start withdrawing on their assets immediately, having too much cash can serve as a drag on fund performance.

3)   Underlying Funds: TDFs typically have different funds managing different sections of the portfolio. An investor should look at these underlying funds to assess whether each fund manager makes sense within the context of their portfolio. Remember, the TDF is not individually customized. Its purpose is to serve a wide group of investors who may have a variety of goals and objectives.

The following are some basic questions about the underlying funds that every investor should consider before deciding on a TDF. Is there exposure to a myriad of asset classes that are unnecessary to meet your goals? Is the weighting to certain areas of the market too large for your needs? Furthermore, is the TDF only allocating capital to a single mutual fund family to benefit the parent company or are they using a variety of different managers?

An investor’s interest may differ from those of the company running the TDF. Therefore, it’s important to look under the hood to see how your money is being allocated.

4)   Active vs. Passive: Some investors are proponents of indexing, or passive investment strategies that track the market. Others may subscribe to the philosophy of active management, where they believe hiring a knowledgeable manager is the most prudent approach. Thankfully, there are TDFs that offer both options, as well as hybrid strategies. It’s important that the investor is utilizing a TDF that subscribes to their beliefs so they are more inclined to stick with the strategy over the long-term.

5)   Fees: Fees can vary greatly between TDF providers. Cheaper is not always better, but there is also no reason to pay substantially more than industry averages. It behooves every investor to benchmark the fees of various TDFs before making any decisions.

It also pays to consider the level of service being provided. If a retiree merely plans to buy a TDF to manage their money, but is not getting any financial guidance, then there is no reason to pay fees comparable to working with a full service financial professional. Doing so will meaningfully eat away at one’s long-term returns without anything to show for it.

6)   Lack of Customization: One of the major drawbacks of a TDF is the lack of customization. For example, a retiree with a concentrated investment, whether in company stock or real estate, needs to diversify around that exposure to avoid entering retirement with too much of their wealth tied up in one position. It’s impossible for a TDF to provide appropriate customizations in that situation. The TDF cookie cutter approach may be a deal breaker for some retirees whose planning needs are more nuanced and require a more comprehensive strategy in their retirement plan.

7)   Broader financial planning goals: It’s important to ensure the TDF fits within an investor’s broader financial planning goals. The following are some items that may span beyond the purview of what a TDF can offer. Coordinating several income streams from various assets accumulated over the course on one’s career. Creating a tax efficient withdrawal strategy considering other income sources. Establishing an asset allocation that complements any outside investments. Additionally, if leaving a legacy to one’s heirs, planning for a much longer time horizon than just your retirement year.

TDFs are undeniably a great first step towards retirement planning. However, it’s also important to understand their limitations. They are unable to factor in outside investment, social security and pension income. They cannot build a strategy around your health, the health of your spouse, family dynamics, or when and where you decide to retire. Nor can they manage sequence of returns risk or account for how long someone is in retirement. While there is an elegance to the simplicity of a TDF, there are also many areas where they come up short. Investors should plan accordingly.

Disclaimer: This article authored by Jonathan Shenkman a financial advisor at Oppenheimer & Co. Inc. The information set forth herein has been derived from sources believed to be reliable and does not purport to be a complete analysis of market segments discussed. Opinions expressed herein are subject to change without notice. Oppenheimer & Co. Inc. does not provide legal or tax advice. Opinions expressed are not intended to be a forecast of future events, a guarantee of future results, and investment advice. Investing in securities is speculative and entails risk. There can be no assurance that the investment objectives will be achieved or than an investment strategy will be successful. Investors must carefully consider a fund’s investment objectives, risks, charges and expenses of the investment before investing. This and other information, including a description of the different share classes and their different fee structures, are contained in a fund’s prospectus. You may obtain a prospectus from your Financial Professional. Please read the prospectus carefully before investing. Adtrax #: 3347690.1