Are you considering using target date funds in retirement? 7 key considerations to keep in mind
When reviewing a client’s 401 (k) plan, I’m pretty excited if I see a decent target date fund (TDF) option in their range of investments. I firmly believe that a TDF is one of the best default investment vehicles in most company pension plans.
The operation of a TDF is simple. You choose the fund that corresponds to your approximate year of retirement. The money in this fund is invested according to a time horizon until that year of retirement. For example, a 35-year-old investor who intends to retire in 30 years to 65 may want to choose a fund with a target date of around 2050. FTDs allow investors to manage in a transparent and prudent manner. their retirement assets with just one fund and minimal work. This is a suitable investment solution in 401 (k) plans, where investors typically have limited investment choices and may be in the accumulation stage of retirement planning.
However, as the disbursement phase of retirement planning approaches, it is essential to exercise due diligence before incorporating FDD into your plan. Understand the differences between the various TDFs available in the market and where they may not help retirees meet their financial goals.
1) Descent path: Each TDF has what is called a descent path. The descent path represents the change in the composition of the fund’s investments, including stocks, bonds and cash, over time. When investors are further away from retirement, they can afford to be more aggressive, and the asset mix is more heavily weighted in stocks than in bonds and cash. As the investor approaches their target retirement date, the fund “slides” into a more conservative allocation with higher quality bonds.
It is important to know that the philosophy of the appropriate descent path may vary depending on the family of funds that manages the TDF. Some descent paths maintain a higher stock allocation than others, even after retirement. The personal circumstances of the investor would dictate whether this can be beneficial or too risky.
For example, an individual who retires from full-time work at age 75, who receives 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, n usually does not need its nest. egg to grow rapidly. Therefore, he may not need to take a lot of risk on the stocks and a more cautious allocation may be warranted. The opposite may be true for someone who retires prematurely and has to take more risk in stocks to make sure their money lasts longer during retirement. It is imperative that the TDF’s descent path matches your personal situation.
2) Cash flow situation: The level of liquidity allocation also varies depending on the TDF. Each fund family perceives the distribution of liquidity within its asset mix differently. Additionally, some companies are compensated by paying little or no interest on an investor’s cash flow and keeping that return, however minimal, to themselves. It is important for the investor to determine the cash allocation within his TDF to ensure that it matches his specific needs.
If an investor retires at an early age, he or she may be very concerned about the risk of “return streak,” which is the risk of experiencing several years of unfavorable returns early in retirement. This scenario of withdrawing assets in the middle of a bear market can be financially devastating for an investor. However, if the TDF has a significant cash position, it can act as a buffer against negative returns. Conversely, if the retiree has other sources of income and does not need to immediately start withdrawing assets, having too much cash can adversely affect the performance of the fund.
3) Underlying funds: TDFs typically have different funds that manage different sections of the portfolio. An investor should look at these underlying funds to determine if each fund manager makes sense in the context of their portfolio. Remember that the TDF is not individually personalized. Its purpose is to serve a large group of investors who may have a variety of goals and objectives.
Here are some basic questions about the underlying funds that every investor should consider before choosing a TDF. Is there exposure to a myriad of asset classes that are not necessary to achieve your goals? Is the weighting of certain areas of the market too important for your needs? In addition, does TDF only allocate capital to one family of mutual funds for the benefit of the parent company, or does it use different managers?
The interest of an investor may differ from that of the company which manages the TDF. Therefore, it is important to look under the hood to see how your money is being allocated.
4) Active vs passive: Some investors are supporters of indexation or passive investment strategies that follow the market. Others may subscribe to the philosophy of active management, where they believe that hiring a competent manager is the more prudent approach. Fortunately, there are TDFs that offer both options, as well as hybrid strategies. It is important that the investor uses a TDF that agrees with their beliefs so that they are more inclined to stick to the long term strategy.
5) Fees: Fees can vary widely between TDF providers. Cheaper isn’t always better, but there’s also no reason to pay much more than the industry average. It is the responsibility of each investor to compare the charges of various TDFs before making any decisions.
It is also useful to consider the level of service provided. If a retiree is simply considering purchasing a TDF to manage their money, but does not get any financial guidance, there is no reason to pay a fee comparable to working with a full-service finance professional. This will drastically reduce returns in the long run with nothing to prove it.
6) Lack of customization: One of the major drawbacks of a TDF is the lack of customization. For example, a retiree whose investments are concentrated, whether in company stocks or in real estate, must diversify around this exposure to avoid retiring with too much of his fortune tied to a position. It is not possible for a TDF to provide appropriate customizations in this situation. The TDF cookie cutter approach may be a deciding factor 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 is important to ensure that the TDF fits within the broader financial planning objectives of an investor. Here are some things that may go beyond what a TDF can offer. Coordinate multiple streams of income from various assets accumulated during his career. Create a tax-efficient withdrawal strategy taking into account other sources of income. Establish an asset allocation that complements any outside investment. Also, if you leave an inheritance to your heirs, plan for a time horizon that is much longer than your retirement year.
TDFs are undeniably an important first step in retirement planning. However, it is also important to understand their limitations. They are unable to take into account foreign investments, social security and retirement income. They can’t strategize around your health, the health of your spouse, family dynamics, or when and where you decide to retire. They also cannot manage the sequence of return risk or account for the length of a person’s retirement. While there is an elegance in the simplicity of a TDF, there are also many areas where they fall short. Investors should plan accordingly.
Disclaimer: This article was written by Jonathan Shenkman, Financial Advisor at Oppenheimer & Co. Inc. The information presented in this document was taken from sources believed to be reliable and does not claim to be a comprehensive analysis of the market segments discussed. . The opinions expressed in this document are subject to change without notice. Oppenheimer & Co. Inc. does not provide legal or tax advice. The opinions expressed are not intended to be a forecast of future events, a guarantee of future results and investment advice. Investment in securities is speculative and involves risk. There can be no assurance that the investment objectives will be achieved or that an investment strategy will be successful. Investors should carefully consider the investment objectives, risks, fees and expenses of a fund before investing. This and other information, including a description of the different classes of shares and their different fee structures, is contained in a fund’s prospectus. You can get a prospectus from your financial professional. Please read the prospectus carefully before investing. # Adtrax: 3347690.1