Target Date Funds Be Like...
Target Date Funds Be Like…
Target Date Funds, sometimes referred to as LifeCycle Funds, have been advertised as an “easy and convenient way” for individuals to manage their Retirement and Education accounts. According to the Investment Company Institute, $678 billion was invested in Target Date Funds as of June 2014. At the risk of oversimplifying, Target Date Funds automatically reduce your portfolio’s equity exposure (and increase your allocation to Bonds and Cash) as the “target date” gets closer. The idea being that a portfolio containing more Fixed Income investments is “safer” than one containing greater equity exposure.
What if Target Date Funds are constructed based on flawed assumptions? Target Date Funds were invented in the early 1990’s when the Federal Funds Rate was approximately 8%, the interest rate on a 30yr Fixed Mortgage was approximately 10%, and banks were offering 1yr Certificates of Deposit (CDs) that paid nearly 8%. Today, the Federal Funds Rate is zero, the interest rate on a 30yr Fixed Mortgage is approximately 4.25%, and 1yr CDs pay less than 1%. With the Federal Reserve poised to raise rates in the coming months, many investment strategists believe that we are witnessing the end of a 30yr Bull Market in Bonds. As interest rates rise, many Fixed Income investments will lose value. What if Fixed Income investments only seemed “safer” because we interest were in steady decline? What if pre-retirement Baby Boomers are piling into Bonds just as interest rates are about to rise?
In addition to the issues above, there are other items of concern with Target Date Funds:
- Most Target Date Funds are comprised entirely of Mutual Funds. Mutual Funds are perpetual investments, (i.e., they don’t have a maturity date) and are subject to daily fluctuations as markets reprice. That means that in addition to “Absolute Risk,” investors are subject to “Volatility Risk.” Note: For a list of risk types, see our Blog Post titled “How Do YOU Define Risk?”
- Mutual Funds tend to carry higher expense ratios than their passive counterparts, Exchange Traded Funds (ETFs). Additionally, Target Date Funds are typically “Funds of Funds” which means two layers of fees.
- The Fixed Income choices in many Target Date Funds are predominantly “core fixed income” funds with heavy exposure to US Treasurys. US Treasurys tend to be the most interest rate sensitive of all bonds. Other segments of the Fixed Income market such as TIPS, Floating Rate Bank Loans, Emerging Markets Debt, and High Yield Bonds often outperform Treasurys in a rising rate environment.
- Asset Allocation decisions in Target Date Funds are made based solely on age, without any consideration for your risk tolerance, volatility tolerance, need for income, or other investment holdings.
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