By Brian Hufford, CPA, CFP®
Whenever a dentist offers target date funds (TDFs) as a choice in an office-sponsored 401k plan, these funds are by far the most popular alternative for staff as compared to having to select and diversify among a roster of mutual funds.
Most participants tend to simply align the date of the TDF with their presumed retirement date or their assumption that longer-dated funds are more aggressive and shorter-dated funds are more conservative. Presumably, this allows the participant to fit a risk tolerance.
In a recent article about TDFs, The Problem with Target Date Funds, authors Richard and Robert Michaud offer an enlightened analysis about the ability of TDFs to fit an investment objective, such as retirement. TDFs are known by their specific retirement goal date, such as the Vanguard Retirement 2025 fund.
Investors tend to make three basic assumptions about TDFs: there is a well-accepted retirement risk glide path that all funds follow, each fund properly diversifies appropriately among many investment choices, and investment costs are minimized in the pooled structure.
Let's examine these assumptions in order to gain insights about investing for retirement.
1. There is a well-accepted retirement glide path.
The authors of the article on TDFs state that most use age-based rules that decrease equity or stock risk as retirement approaches. Many investors have heard of a common rule of thumb stating that the amount of bond exposure should be equivalent to one's age. For instance, a 30-year-old should have 30% in bonds and a 70-year-old should have 70%. But according to the authors, the year 2008 revealed that stock exposures among TDFs varied widely, from 26% to 72%, for a 2010 retirement goal. Losses for 2010-dated TDFs averaged 23% with the worst performer down by 42% compared to a loss for the S&P 500 Index of 37% in 2008.
The authors concluded that there is no consensus in theory or in practice for defining age-based stock-to-bond ratios. Each investor has a unique retirement glide path determined by the individual investor's ability, willingness, and need to take risk. There is no guarantee that any TDF aligns with that glide path.
2. TDFs diversify appropriately among investment choices.
Widely used TDFs are offered by management companies that typically select from their existing family of mutual funds or exchange-traded funds. In other words, it would be hard to imagine that Fidelity would regularly add Vanguard funds to its TDF retirement offerings. While large management companies do have a large number of investment choices among their families, it is easy to question if the management company roster contains the best alternative for each investment type and whether the management company offering is limited in its ability to diversify by having to select within a closed box of offerings. Ideally, each retirement investor would be able to select from the best alternative for each asset class within an open-ended universe of choices, not limited by one management company's offerings.
3. Investment costs are minimized in TDFs.
Thanks to the proponents for index investing, investors have been made aware of how important it is to limit overall portfolio costs. While academics may disagree about the extent of overall market efficiency (the Efficient Market Hypothesis), no one disputes that portfolio costs present a challenge to overall portfolio performance. While commissions may be limited or nonexistent for many TDFs, the funds themselves are a composite of the management expenses represented within their fund choices. These costs may be rather low among index-like management companies and extremely high among some brokerage-firm offerings. Still, as in the freedom to diversify among the entire universe of investment choices, there may be lower-cost offerings available when the investor is allowed to select outside the closed box of one management company. This applies to management companies that are index proponents as well as to brokerage firm offerings.
In summary, TDFs have brought about an easier solution to diversify a retirement portfolio with a specific retirement date in mind; however, in the one-size-fits-all world of TDFs, there might be a much better fit for your retirement needs – one that has the freedom to match your goals with the entire universe of investment choices available.
Brian Hufford, CPA, CFP®, is CEO of Hufford Financial Advisors, LLC, an independent, fee-only planning firm that helps dentists achieve financial peace of mind. Contact Hufford at (888) 470-3064 or [email protected].
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