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FP Explains: How target-date funds can help you hit the retirement bullseye

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© Getty Images/iStockphoto files The two biggest arguments against TDFs centre around asset allocation decisions and the portfolio size effect on returns.

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By Julie Cazzin, with Allan Norman

You’re likely heard of target-date funds (TDFs) and wondered what they are and whether they should be part of your portfolio.

In basic terms, they are designed for simplicity, a one-fund solution so everyone has a successful investment experience.

Your TDF investment will be managed by a portfolio manager who will, based on certain criteria, select and monitor individual investments, and maintain the appropriate mix of equities and bonds as well as specific geographic mix. They will also adjust the mix of equities and bonds as you age.

The word “glidepath” is often associated with TDFs and it is a good way to visualize such a fund in action: you are gliding into retirement just like a jet coming in for a landing. Put another way, it’s a lot like an investment road map that takes someone from a start date to an end goal. Yes, that could be retirement, but it could also be your child’s university education, or some other goal.

The concept is simple. There is time to recover from any investment mishaps or volatility when you are young with lots of working years ahead of you. As you approach retirement, you don’t have the same recovery time and your portfolio gradually shifts from a high-equity/low-bond mix to a lower-equity/higher-bond mix.

This gradual automated investment (asset) mix change makes TDFs worthy of consideration for any investment goal with a fixed time horizon such as a registered education savings plan (RESP) or saving for retirement.

Most TDF funds are labelled with acronyms such as TDF 2035, TDF 2040, TDF 2045. This is so you just have to pick your planned retirement date and then invest in the corresponding fund. For instance, if you are retiring in 2040, select TDF 2040 as your investment choice.

If your retirement date is 2042, you would pick either TDF 2040 or TDF 2045 based on your tolerance for risk or fluctuations. The TDF 2040 is the more conservative fund because the retirement date is earlier.

Of course, you don’t have to follow the intended convention and you can select whatever TDF you think will best suit your circumstances.

Like other investment funds and exchange-traded funds, TDFs will differ between companies in terms of fees, investment styles (active/passive), the mix between equities and bonds, and even the slope of the glidepath. These are all things to consider if you want to look further than the basic concept.

Probably the two biggest arguments against TDFs centre around asset allocation decisions and the portfolio size effect on returns.

First, a traditional asset allocation for a retirement portfolio might be equally split between equities and bonds, but that may not make sense for all portfolios.

Imagine you have either a $100,000 portfolio or a $1-million portfolio with a need to draw $50,000 per year. This is an extreme example, but it happens.

The $100,000 portfolio should probably be all bonds or cash. Does your $1-million portfolio need $500,000 in bonds? That gets you about 10 years of income ($50,000 times 10 years) protected against market volatility. If you are conservative, it might be perfect, but you may not want as much in bonds if you are a little more aggressive.

The second argument against TDFs has to do with the portfolio size effect and its impact on returns. Younger people with a smaller account have a higher return potential with a higher equity component. As you age and your portfolio gets larger, your potential return declines as you add bonds.

This is easier to understand if you imagine not making a change to your investment mix. A $10,000 portfolio making 10 per cent earns $1,000 while a $1-million portfolio making 10 per cent earns $100,000.

It has been argued a TDF may move too quickly to bonds and, as a result, give up earnings. It comes back to your goals and comfort level with investing.

There are a few investment firms that offer TDFs to individuals, but the majority of TDFs are offered within workplace contribution plans.

As mentioned at the beginning, TDFs offer a simplified investment strategy designed to be set on auto pilot and may be a great option for some people. But recognize they don’t account for your lifestyle goals, other investments and other income sources, so it’s best to think about how they may fit into your overall plan before purchasing.

If you’re interested in these funds, it’s worth talking to your adviser to better understand exactly how they would fit into your long-term investment and retirement plan.

Financial Post

Allan Norman, M.Sc., CFP, CIM, RWM, is both a fee-only certified financial planner with Atlantis Financial Inc. and a fully licensed investment adviser with Aligned Capital Partners Inc. He can be reached at www.atlantisfinancial.ca or alnorman@atlantisfinancial.ca This commentary is provided as a general source of information and is intended for Canadian residents only.

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