While there’s a generally accepted consensus that the average American plans to retire at age 65, there are divergent paths to build an investment plan to prepare for that milestone.
The first path offers the traditional risk-based funds — also called lifestyle funds — which are based on the investor’s tolerance for risk: conservative, moderate or aggressive. The second, and more recent, path offers a target date fund, which bases its asset allocation on an individual’s expected year of retirement.
Which path is the best for investors, and what has been the driver behind the newer target date funds?
Risk-based funds include a mix of equities, bonds and cash that reflects the individual’s appetite for investment risk. As time goes on and the individual nears retirement, the risk-based fund requires periodic review and action by the individual in order to shift the portfolio to one that is more conservative over time.
Creating a simple way to invest for retirement
With the advent of auto-enrollment features for employees, more plan sponsors need to make investment choices for their retirement plan participants. An easy way to make this decision for a participant is to base it on when the employee turns 65. This allows the plan sponsor to select a fund without having to know the individual’s risk tolerance.
The target date fund also appeals to investors because they can theoretically set it and forget it without having to re-evaluate their stock and bond allocation. These funds have an internal glide path that transitions the allocation from one of higher risk (furthest from retirement) to one that is much more conservative (as the investor nears retirement). However, there is no industry standard that defines or articulates the recommended glide path.
Although target date funds appear simpler, there are disadvantages. For example, the 2008 stock market decline triggered questions about how target date funds are invested. Beyond having a date, such as “2020,” in its title, the name of the fund doesn’t say how it is invested. Beyond knowing the fund will gradually become more conservative, it is not evident as to what that mix of equities, bonds and cash will look like over time.
In contrast, the proportion of equities, bonds and cash is generally easier to understand in risk-based funds. Perhaps the biggest distinction between target date and risk-based funds is that risk-based investing involves more evaluation at the start. Investors complete a quiz in order to determine their comfort with risk and how it intersects with their expected retirement age.
Why is the customized evaluation of an individual’s risk profile so important if it is generally accepted that investors should reduce risk over time? The reality is that each individual has unique circumstances and expectations. For example, some 60-year-olds have a greater appetite for risk than 30-year-olds. In married couples, one spouse might want a more aggressive mix of equities if the other spouse is weighted in more conservative options. The starting and ending points for individuals might look dramatically different even though both investors become more conservative as retirement nears.
When evaluating which fund type to choose, investors should consider three key questions:
What is your risk profile?
Regardless of fund type, it’s important for investors to determine their risk profile. They should consider their knowledge of the markets and, if they had $10,000 to invest, what kind of loss would be intolerable. They also should consider what other types of investments they have.
What is the mix of investments in each fund?
Look beyond labels like “conservative.” The asset allocation can be dramatically different between similarly labeled funds. The same is true for target date funds with the identical targeted retirement date. Individuals need to understand the mix within the investments in order to fully compare risk-based and a target date funds.
How is the fund managed and what are the expenses?
Find out whether the fund has more of an index or an actively managed approach. In general, index funds have lower expenses than actively managed funds. Since expenses eat away at returns, it is important for participants to know the costs associated with their investments.
Then choose one
One oddity that financial advisers have noted is some investors believe they should diversify their retirement savings by investing in multiple target date or risk-based funds. While investors have long been encouraged to diversify so they have a proper mix of equities, bonds and cash, the same principle does not apply to mixing these types of funds. Investors should pick one target retirement or one risk-based fund.
The emergence of the target date fund reflects the need for investors to be better educated about their appetite for risk and diversification in general. The best argument for a target date fund is that it encourages retirement investing through its simplicity. However, from the viewpoint of creating a fund that is tailored to the individual, risk-based funds have the advantage.
Tara Mashack-Behney is a partner and director of investment consulting at Conrad Siegel Actuaries, an employee benefits firm in Harrisburg.