Are you planning to retire within 10 years? Do you own a life-cycle fund, also known as a target-date fund, or TDF? If you answered "yes" on both counts, beware: You're in the "risk zone."
That's the period when retirement begins within a decade. It's also a time when asset allocation -- the mix of stocks, bonds and other asset classes -- becomes unusually hazardous for target-date fund shareowners, warns Ron Surz, president of Target Date Solutions, an investment management and research firm. He says that these products generally harbor too much equity exposure in the risk zone -- a period when the emphasis should be on preservation of assets.
"2008 was a wake-up call," Surz says. The dramatic losses in stocks that year are a powerful reminder that as retirement approaches, target-date funds should focus on safety. But most life-cycle funds don't sufficiently wind down equity risk as the target date approaches, he warns. As a result, most target-date fund investors within a decade of retirement may be courting trouble.
Surz follows his own philosophy in the SMART Funds, which he runs. The SMART Funds 2010 portfolio, for instance, was recently allocated almost completely in cash and inflation-indexed Treasuries. "When you're nearing retirement, presumably you've done a good job of building up assets," he says. "You're going to start relying on those assets and so you should be fairly protective of those balances."
Different philosophiesThe reality is that many target-date funds are being run with investment horizons that extend well beyond the target date. As a recent advisory from the U.S. Department of Labor and Securities and Exchange Commission noted, "Some target-date funds may not reach their most conservative investment mix until 20 or 30 years after the target date."
A review of target-date funds using Morningstar Principia software confirms the government's warning. Of the 49 funds with target dates no later than 2010, 47 recently had equity allocations that ranged from about 2 percent up to 64 percent of assets, with just two reporting no stock holdings. More than three-quarters of these target-date funds had equity allocations above 30 percent and in some cases, well above 50 percent. By Surz's reasoning, all 49 funds should have equity allocations at or near zero.
Target date 2010 funds' equity allocations
Source: Morningstar Principia (April 2010 edition)
But as the variation in TDF asset allocations suggest, there's some debate on what's prudent. Jerome Clark, who oversees 12 target-date funds at T. Rowe Price, says that retirees need to generate income to match lengthening lifespans. He says that for a couple who are both 65 years of age, the odds of one person living to 90 is over 50 percent; there's a 25 percent chance of living to 95. "You need equity in the portfolio to combat inflation."