“Would the Target Date funds offered by my employer be a sufficient alternative to active asset allocation?”

This is a question many investment professionals address regularly and there is no easy answer. However, contained herein is an attempt to describe Target Date funds and contrast them to active asset management.

Asset allocation models are rubrics that dictate the mix of stocks, also known as equities, and bonds, also known as fixed income, within a portfolio. Historically, stocks have both a higher return, or reward, and a higher standard deviation, or risk. Therefore, all else equal, an investor with a longer time horizon may have a larger exposure to stocks than an investor with a shorter time horizon. Target Date funds identify the investors’ time horizon and assign an allocation to stocks and bonds accordingly. An algorithm is then used to rebalance that allocation as the investor moves closer to his or her retirement date. In contrast, active asset allocation takes into account more information including, but not limited to 1) investor sentiment, 2) prevailing market conditions, 3) investor-specific tax needs, and 4) investor’s liquidity and downside protection requirements. Put simply, a target date fund will group together all investor’s with the same “target date” for their retirement whereas active asset allocation may be more specific to the individual.

“If there is a magic mix of equity and fixed income that will best serve a client retiring on a specific date, why deviate from that?”

Unfortunately, no magic formula exists.  The allocation within Target Date funds is specific to each investment management company and can vary amongst fund families.  As a result, performance can vary drastically.  Target Date funds remain ubiquitous in the employer pension program because employers see these choices as a means of lessening their fiduciary responsibility. By defaulting to Target Date funds for those employees who do not readily make investment choices, employers can justify their inaction on behalf of those investors.

It is important to note that the principal value of a target date fund is not guaranteed at any time, including at the target date. Investing in equities and bonds involves risk.

What are the potential benefits of active asset allocation?

Those in opposition of the Target Date fund approach cite the fact that asset allocation should take into account far more than just the time horizon of the investor. Risk tolerance, liquidity needs, and the full financial picture of the client should be addressed when constructing an investment strategy. Furthermore, asset allocation should adjust in response to capital market expectations. For example, a specific market sector or geographical region may face near-term risks that prompt a skilled manager to avoid investments that are sensitive to those factors. A Target Date fund with a strategic asset allocation will be unable to respond in a tactical way to these events.

The downside to Target Date funds is more obvious over shorter periods of time than longer periods. Last year, individuals who had more conservative target date funds, and by direct consequence a greater exposure to long-term bonds, most likely suffered a significant decline in market value due to the increase in interest rates. Limitations in the investment policy statement of a Target Date fund may prevent defensive strategies to address rising interest rates. With a federal funds rate near zero and the on-going tapering of quantitative easing, the next 3-5 years is likely to accommodate higher interest rates. We believe rising rates will drive investors seeking income toward high yield equities and tactical fixed income strategies, as opposed to the strategic asset allocation one finds in a Target Date fund.

By the same principle, i.e., a commitment to a preordained asset allocation, Target Date funds have difficulty addressing global trends with regard to emerging markets and commodities investments. Funds with a mandate to maintain an exposure to gold and precious metals, for example, most likely have experienced significant losses in that allocation of their portfolio over the last 3 years.

The last and probably the most significant point would be using Target Date funds for aggressive objectives, i.e., for those individuals who simply want to take advantage of what they believe to be the most beneficial allocation for growth without any time consideration. We encourage the interested reader to contact our office to discuss the difference in the performance of the most aggressive target date funds and the performance of the S&P 500. This comparison, especially on a risk-adjusted basis, is quite noteworthy.

Investing in equities, bonds, and other securities involves risk of principal investment. Bonds are subject to market and interest rate risk if sold prior to maturity.

The Legacy Foundation Approach

The risk-reward theme is one that transcends the investment universe. Investors expect compensation commensurate with the risk they face. “Risk-seeking” behavior is, however, a caveat. Having exposure to what would be considered ‘higher’ risk investments does not guarantee higher returns or positive returns, especially over longer investment horizons. It is Legacy’s opinion that aggressive investors might find the most success by increasing the breadth of their investment strategy and, consequently, decreasing the holding period of their investments. Part of The Legacy Foundation’s portfolio management strategy is an emphasis on sector funds, offered through employer plans. These funds permit an overweighting in attractive areas of the equity market and provide a venue to increase alpha exposure. Of course, successful implementation of such a strategy demands a devotion of time and the availability of tools to perform unbiased market research.

No strategy can assure a profit or protect against a loss. Investments in all mutual funds involves risk of principal invested.

At the Legacy Foundation, we are committed to providing comprehensive financial planning services. Our advice is the product of thorough review of your entire financial position, gleaned from a thorough series of meetings to assess risk tolerance, short- and long-term financial goals, tax issues, and retirement planning. Our asset management model is a comprehensive program, reviewed in detail in the articles that follow below.

Your employer pension programs represent the cornerstone of your retirement income and it has been our experience that personal financial planning and personal account reviews that are ongoing throughout your career are the best way to pursue your retirement success. At the Legacy Foundation we understand that creating and managing wealth demands more time, attention, and research than it ever has. Financial planning and investment strategies are complex challenges. We have developed the tools and possess the personal commitment to meet these challenges.

If you are interested in learning more about our firm, we encourage you to visit our website, https://www.yourlegacyfoundation.com/staging. For more information, please contact our office by phone at (434) 971-5917 or via email at jesau@www.yourlegacyfoundation.com.

Please stay tuned for information about our annual seminar that will take place in the fall.

Judy L. Esau, ChFC, AAMS