Mutual Funds

Throwing Darts at Target Funds

An investment expert argues that life-cycle funds aren't as foolproof as they seem.

From Kiplinger's Personal Finance magazine, November 2007

Drew Carrington's division at UBS Global Asset Management offers 401(k) sponsors a new generation of retirement funds.

Target-date funds are big sellers. You just pick a date, and the manager does the rest. What's not to like? The current generation of funds doesn't address certain risks -- the risk that inflation or a market downturn close to retirement age will erode too much of your savings, that you're not diversified enough, and finally, that you'll outlive your savings.

How do you solve those problems? If you're going to use fixed-income securities to take risk out of the portfolio, you should use more inflation-linked bonds, such as Treasury inflation-protected securities, or TIPS. We're also big fans of strategic asset allocation to manage market risk. Most funds set a glide path from stocks to bonds, then don't pay attention to it -- it's like getting on an airplane and hearing the pilot say you're going to fly through thunderstorms but on autopilot. The idea that you can determine today the best weights for various classes of securities far into the future is unreasonable.

Target funds often own a bunch of other funds. Aren't they diversified? In general, target funds don't own enough non-U.S. securities, real estate investment trusts, emerging-market securities or high-yield bonds. We might own more non-U.S. than U.S. stocks if we think values justify it.

How do you guarantee you won't outlive your savings? You can't hedge longevity risk by buying more stocks. You might increase the probability that the money will last, but you also increase the magnitude of how bad things can go if you're wrong. The only way to hedge is with insurance -- say, an annuity. You don't have to annuitize all your wealth, just a portion.

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