FP Explains: How Target Date Funds Can Help You Hit the Retirement Rose

Pension Personal Finance FP Investor

Target date funds are a simple investment option that makes it easy to save and invest. But should everyone have one? These are the pros and cons

Publication date:

Jan 14, 2022 • Jan 14, 2022 • 4 minute reading time • Join the conversation The two biggest arguments against TDFs focus on asset allocation decisions and the effect of portfolio size on returns. Photo by Getty Images/iStockphoto Files

By Julie Cazzin, with Allan Norman

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You’ve probably heard of target-date funds (TDFs) and are wondering what they are and whether they should be part of your portfolio.

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

Your TDF investment is managed by a portfolio manager who, based on certain criteria, selects and monitors individual investments, maintaining the right mix of stocks and bonds and a specific geographic mix. They will also adjust the mix of stocks and bonds as you age.

The word ‘glide path’ is often associated with TDFs and it’s a good way to visualize such a fund in action: you slide into retirement, much like a jet coming in for a landing. Put another way, it’s a lot like an investment roadmap that takes one from a start date to an end goal. Yes, it could be retirement, but it could also be your child’s college education, or some other purpose.

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The concept is simple. There is time to recover from any investment mishaps or volatility if you are young and have many years of work ahead of you. As you retire, you will not have the same recovery time and your portfolio will gradually shift from a high equity/low bond mix to a lower equity/higher bond mix.

This gradual automated change of investment mix (assets) makes TDFs worth considering for any fixed time horizon investment goal, such as a Registered Education Savings Plan (RESP) or saving for retirement.

Most of the TDF funds are labeled with acronyms such as TDF 2035, TDF 2040, TDF 2045. So all you need to do is choose your planned retirement date and then invest in the corresponding fund. For example, if you are retiring in 2040, select TDF 2040 as your investment choice.

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If your retirement date is 2042, choose TDF 2040 or TDF 2045 based on your tolerance for risk or fluctuation. The TDF 2040 is the more conservative fund because the retirement date is earlier.

Of course, you don’t have to stick to the intended convention and you can select the TDF that you think best suits your circumstances.

Like other mutual funds and exchange-traded funds, TDFs will vary between companies in terms of fees, investment styles (active/passive), the mix between stocks and bonds, and even the slope of the slide. These are all things to take into account if you want to look beyond the basic concept.

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

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

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

The $100,000 portfolio should probably all be bonds or cash. Does Your $1 Million Portfolio Need $500,000 in Bonds? That gives you about 10 years of income ($50,000 times 10 years) protected from market volatility. If you’re conservative it might be perfect, but you might not want that much in bonds if you’re a little more aggressive.

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

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This is easier to understand if you imagine not changing your asset mix. A $10,000 portfolio that earns 10 percent earns $1,000, while a $1 million portfolio that earns 10 percent earns $100,000.

It has been argued that a TDF could switch to bonds too quickly and give up income as a result. It comes back to your goals and comfort level with investing.

There are a few investment firms that offer TDFs to individuals, but most TDFs are offered as part of workplace incentive plans.

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As mentioned at the outset, TDFs offer a simplified investment strategy that is designed to be put on autopilot and can be a great option for some people. But realize that they don’t take into account your lifestyle goals, other investments, and other sources of income, so it’s best to think about how they fit into your overall plan before buying.

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

Financial item

Allan Norman, M.Sc., CFP, CIM, RWM, is both a Certified Paying Financial Planner at Atlantis Financial Inc. and a fully licensed investment advisor at Aligned Capital Partners Inc. He can be reached at www.atlantisfinancial.ca or alnorman@atlantisfinancial.ca This comment is intended as a general source of information and is intended for residents of Canada only.

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This post FP Explains: How Target Date Funds Can Help You Hit the Retirement Rose

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