Research has shown 401(k) plan participants often miss the mark in designing age-appropriate investment portfolios for retirement. Often, workers take an all-or-nothing approach, either putting all of their assets in stocks or leaving everything in cash or other conservative fixed-income vehicles.

Research has shown 401(k) plan participants often miss the mark in designing age-appropriate investment portfolios for retirement. Often, workers take an all-or-nothing approach, either putting all of their assets in stocks or leaving everything in cash or other conservative fixed-income vehicles.



Part of the challenge for 401(k) plans is that participants may lack the time or desire to consider all of their plan's investment alternatives. For these indecisive employees, 401(k) plans provide a default investment option, which in the past has been either a low-risk money market fund or a balanced fund with a static allocation to stocks and bonds. Unfortunately, these default investments were unlikely to be appropriate for all of a company's employees. For younger workers, the money market fund was too conservative. For those close to retirement, the balanced fund could mean taking on more risk than they were comfortable with.



The need for an age-appropriate default investment option set the stage for the emergence of target-date funds which have seen growing acceptance by both plans and participants. According to data from Vanguard, more than 60 percent of new participants in its 401(k) plans invested exclusively in target-date funds.



Target-date funds are built to provide investors with a simple way to invest in a diversified portfolio that automatically becomes more conservative over time. Instead of having to build their own portfolio and determine when and how to adjust their asset allocation as they approach retirement, investors can simply select a mutual fund built with their retirement time-frame in mind.



For example, a 25-year-old employee planning to retire at age 67 might select a target-date fund designed for retirement in the year 2055. This fund would start with as much as 85 percent to 90 percent of its assets allocated to stocks, then gradually shift assets into bonds and cash as the investor nears retirement age.



While the simplicity of this approach has some appeal, target-date funds have some pitfalls that should be well understood before relying on them exclusively for retirement investing. For starters, investors must understand how their target-date fund is designed to operate. While all target-date funds provide for a glide path designed to reduce risk over time, not all target-date funds have the same view of what a portfolio should look like both when a worker is starting his or her career, and at retirement age. Mutual fund companies offering these funds tend to play to their strengths. Those with greater expertise in stock market investing tend to allocate more of all of their target-date funds to this asset class. Bond-oriented fund companies tend to take the opposite view.



For investors, this ultimately means that two funds with the same target-date in their name can have vastly different asset allocations, and risk profiles, at retirement. Investors who make their decision to buy a target-date fund solely based on its name might be surprised to find that their portfolio has as much as 70 percent of its assets in stocks at retirement. Investors must ensure any target-date fund's asset allocation fits well with their willingness and ability to take on risk. For some, a particular target-date fund with a large allocation to stocks at and after retirement may prove to be too volatile. For others, a specific target-date fund might not provide enough protection against inflation. Investors with assets outside their 401(k) plan should consider their entire portfolio in devising an asset allocation that will meet their goals.



In addition, putting an asset allocation on autopilot via target-date funds can mean making investment changes without giving consideration to current market conditions. For today's retirees living in a low-interest-rate environment, a target-date fund with a large allocation to bonds may not be ideal as future returns are likely to be muted as interest rates rise. For some investors, it may be better to opt for a more customized portfolio that allows for changes to the overall asset mix given the current economic environment.



Like any investment decision, electing to utilize a target-date fund as part of your portfolio requires careful consideration of the potential risks and rewards. Such decisions are always best made in the context of an overall financial plan.



David T. Mayes is a Certified Financial Planner professional and IRS Enrolled Agent at Mackensen & Company, Inc., a fee-only advisory firm in Hampton. He can be reached at 926-1775, david.mayes@mackensen.com or by visiting www.mackensen.com.