Seeking to Build a Dream Portfolio: That’s Why Target Date Funds Exist!

Everyone has an idea about what their “dream home” looks like. How big it is; where the pool is; how many rooms, etc. However, the reality is that almost no one has any idea about how to build a house or for that matter the skill to do it. Let’s face it, it’s complex and most people don’t have the time to dedicate to figuring it out. The bottom line is that it’d take way more time…AND…it’d likely cost way more if you tried to figure everything out yourself.

So, the introduction of mutual funds is like dropping a huge retirement Home Depot down and saying “here’s EVERYTHING you could possibly need for your retirement…now go out and build it.” That’s great, but I still have very little idea what to do. So you’ve got all the materials for a dream house, but understanding the next steps in the construction process can be confusing, overwhelming, and time consuming, similar to building your dream retirement.

A few decades ago, the mutual fund industry began as a means of helping individual investors invest their money. Over that period, mutual funds have evolved from simple stock funds investing in the common stocks of large companies to a tremendous variety of both general purpose funds and specialty funds spanning nearly every potential investment theme you can think of. Along the way, growth in the mutual fund industry has been huge. According to industry estimates, there are over 79,000 funds worldwide investing over US$33 trillion dollars with nearly $18 trillion in the United States alone[1]. Nearly $25 trillion in assets are targeted for retirement, and most importantly for the purposes of this discussion, over $14 trillion dollars are invested in defined contribution plans and IRAs[2].

A Turnkey Operation

So, why do Target Date Funds (TDFs) exist? Well the simple answer is that they exist for a variety of reasons. TDFs serve as sort of the architect and general contractor of building an investor’s portfolio. Someone who knows what everything does, how everything connects, how all the rules work, etc. But before we take a closer look at why TDFs exist, let’s start with a brief history of the target date asset class.

Despite this overwhelming success, in the mid-1990s, it became clear that simply providing the building blocks for an investment portfolio wasn’t enough. The financial industry needed to do more to help investors figure out how to pick from these 79,000 funds to construct a balanced portfolio. Let’s face it; when it comes to sophistication, institutional investors have access to resources unmatched to the traditional 401(k) investor.

Target risk funds were the industry’s first attempt at creating a comprehensive solution to retirement planning for the defined contribution marketplace. They began in the early 1990s with the intention of delivering a diversified portfolio that is designed to provide for a given level of market risk. Since equity volatility generally dominates portfolio volatility, the industry developed portfolios defined by the percentage of equities they held. Aggressive, moderate, and conservative funds were developed with varying levels of equity exposure. These funds generally did a good job of delivering on their basic premise of providing well-balanced, risk-adjusted returns. However, they missed one essential component: investors often do not understand the risk they are taking, nor do they adjust for their own changing risk profiles.

Consequently, out of this confusion emerged a new variation of the risk-based investments – target date funds. TDFs took the financial planning process one step further. Rather than requiring the investor to guess a risk tolerance, they only require an investor to estimate when they would retire. TDFs use a glide path construction that becomes more conservative as the fund gets closer to the “target date” with the goal of mitigating risk. However, let’s not forget that investment risk remains at all times with investing in TDFs.

So although a successful retirement depends upon a number of variables, TDFs help investors take out the worry and work of sorting through the plethora of available investment options. TDFs also exist because they are likely a good investment option for many investors who are not as investment savvy. We believe plan sponsors value TDFs as a qualified default investment alternative because they provide for participants what they likely won’t do for themselves – seek to allocate appropriately to asset classes according to needs over time and automatically rebalance investment holdings.

Indeed, TDFs are an important feature in the 401(k) lineup of most retirement plans. The research firm Cerulli Associates estimates that TDFs will capture 88% of new contributions to retirement plans and represent 35% of total 401(k) assets by the end of 2019. We believe TDFs create a more balanced approach to investing by offering more investment options, representing more asset classes, employing rebalancing, and offering professional money management to the average investor. In doing so, TDFs seek to help investors provide the best opportunity for a successful retirement, similar to your architect and general contractor building your dream home!

[1] Investment Company Institute and International Investment Funds Association

[2] Investment Company Institute, Federal Reserve Board, Department of Labor, National Association of Government Defined Contribution Administrators, American Council of Life Insurers, and Internal Revenue Service Statistics of Income Division. See “The U.S. Retirement Market, Fourth Quarter 2013

 

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About Target Date Funds

Target-date portfolios are managed toward a particular target date, or the approximate date the investor is expected to start withdrawing money from the portfolio. As each target-date portfolio approaches its target date, the investment mix becomes more conservative by increasing exposure to generally more conservative investments and reducing exposure to typically more aggressive investments. Neither the principal nor the underlying assets of target-date portfolios are guaranteed at any time, including the target date. Investment risk remains at all times. Neither asset allocation nor diversification can ensure a profit or protect against a loss in down markets. Be sure to see the relevant prospectus or offering document for a full discussion of a target-date investment option including determination of when the portfolio achieves its most conservative allocation.

Investing involves risk, including possible loss of principal. Equity investments involve greater risk, including higher volatility, than fixed-income investments. Fixed-income investments are subject to interest rate risk; as interest rates rise their value will decline.

Insurance products and plan administrative services are provided by Principal Life Insurance Company. Principal Funds are distributed by Principal Funds Distributor, Inc. Securities are offered through Princor Financial Services Corporation, 800-547-7754, Member SIPC and/or independent broker/dealers. Securities sold by a Princor Registered Representative are offered through Princor®. Principal Funds Distributor, Princor and Principal Life are members of the Principal Financial Group®, Des Moines, IA 50392.

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