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Right Balance Is the Key with Target-Date Funds


Target-date funds are helping average investors get the same type of service wealthy clients have traditionally had when it comes time to transition a retirement plan from being aggressive to a more conservative plan.

The challenge for financial advisors is to establish how aggressive a plan to choose, and what target date to select.

Target-date funds offer a better passive alternative for investors than traditional index funds or balanced funds, which usually hold 60% equities, 40% bonds.

"The main draw of target-date funds is that it's all done for investors," said Andrew Clark, head of American research at research firm Lipper. "Some people don't want to have to make decisions about how much of their money to put into equities and how much to put into bonds, and they don't want to have to decide when to shift from a more aggressive to a more conservative allocation."

Target-date funds have been growing fast, according to Lipper. They rose to 246 funds with $160 billion of assets at the end of last year, up 60% from a year earlier and $8 billion (23 funds) in 2000.

These funds are expected to become even more widespread since the Department of Labor decided to make them an approved default option for 401(k) funds.

A target-date fund might work like this: Say a fund established in 2004 has a maturity date of 2045. For the first 20 years, it may hold 70% of its assets in large-cap domestic equities, 20% in international equities, and 10% in bonds.

Over the next 21 years, the domestic equity allocation would decline 1.5% a year, to 40%, and international equities would drop to 5%. Corporate bonds would rise to represent 60% of assets.

Five years before the target date, inflation-protected bonds would be added to account for 10%.

The client then retires and the fund shifts into distribution mode: Equities would continue to be reduced until, at 10 years past the target date, they would represent just 30% of the fund, bonds would become 65%, and the balance would be in cash.

Some target-date funds have a steep trajectory, only reallocating stocks to bonds two to three years before the target date. Clark said most target-date funds keep about 70% of assets invested in equities until as little as two to five years before the target date.

This strategy should lock in the gains of the aggressive period so they are available at retirement even if the market is down in the target-date year. The period during which the shift from aggressive to conservative occurs is called the fund's glide path.

"These are the funds that are hitting investment goals of clients who want 10% annual gains," he said. He doesn't consider 70% or even 80% in equities to be too aggressive. It all depends on the investor's goal. But such plans are obviously riskier than those with a more gradual glide path.

"There's a tendency to move as close to the edge as possible to maximize the appreciation," said Craig Israelsen, a professor of finance at Brigham Young University in Utah and president of Turnstone Advisory Group, which tracks target-date funds.

Too many target-date funds compete on performance and become too aggressive as they near their target date, Israelsen said.

"You've got people even at the age of 63 looking for 10% returns in their target funds," he said. "But look at the current market. You could end up just before retirement having your fund down 30%! In my view, a target fund should become much more conservative as it approaches the target date. Otherwise there is much too much risk."

He prefers funds where the equity allocation drops to 60% or lower at least five years before the target date. All of Vanguard's funds with targets beyond 2020 start a gradual decline to 50% at 25 years before the target date.

Some funds simply stop reallocating at the target date, but others continue to shift further to income-producing bonds even after the target date. Fidelity Investments' Freedom Funds start out with a 90% allocation to equities, which is reduced gradually to 50% at the target date, but the equity allocation continues to decline for 15 years after the target date, until equities make up only 20% of the portfolio. At that point the portfolio is rolled over into a Freedom Income Fund.

"The whole goal is to provide for retirement income for the client's lifetime," said Dan Beckman, vice president and product manager at Fidelity Institutional Investment Services.

Vanguard's funds continue to reduce the equity allocation for seven years after the target date.

Though some target-date funds have posted returns in the 7% to 8% range, in general they aren't designed as high-octane vehicles. "If your goal is 10% or 12% appreciation, don't choose a target-date fund," Clark said.

Israelsen said target-date funds are a better option for smaller investors than actively managed or balanced funds.

Most are run by Vanguard, T. Rowe Price, and Fidelity. Vanguard has the cheapest, with expense ratios of about 20 basis points, versus an average of 70 basis points, Clark said. T. Rowe Price's funds tend to be more aggressive and more expensive.

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