Think about all the elements you need to be a successful index investor. First, you need to choose the right mix of stocks and bonds, and to adjust that mix as you approach retirement. Your portfolio needs to be broadly diversified and low-cost. You need to save part of your paycheque in a disciplined way, rebalancing your portfolio from time to time, and resist distractions so you won’t be tempted to abandon your plan.
If you have a defined contribution pension plan or group RRSP through your employer, there may be a simple solution: the target date fund. These products were created in the 1990s for workplace investment plans in the US, and they’re now widespread in Canada, with BlackRock’s LifePath and Fidelity’s ClearPath family the most common. These incumbents will now face a challenge from Vanguard, who manages over $358 billion USD in target date funds in the US and recently announced its own series of Target Retirement Funds in Canada.
The idea behind target date funds is brilliantly simple: each one is a balanced portfolio of bonds and global equities in various proportions, from aggressive to conservative. You pick the one with the target date closest to the year you plan to retire: for example, if you plan to retire in 20 years or so, you’d choose a fund with a target date of 2035. Today that fund might be 25% or 30% fixed income, but here’s the hook: the fund will follow a “glide path,” gradually getting more conservative as you approach retirement. By the time the target date is reached, the fund will be primarily in bonds and T-bills.
Many in the financial media like to rip on target date funds, calling them cookie-cutter solutions that don’t account for each investor’s individual needs. But while these funds are not be customizable, they can be an still excellent choice if you’re looking for a workplace plan to complement your self-directed indexed portfolio.
The tyranny of choice
Target date funds were created as a way of helping people with the often overwhelming decisions about how to invest their retirement savings. Researchers have long known that the more funds employees are offered in their workplace plans, the less likely they are to contribute because of analysis paralysis.
Opting out of your company’s plan is usually a huge mistake: if you have the opportunity to make automatic contributions that are topped up by your employer, you should be doing it. Yet it seems that Canadians are leaving about half that money on the table. Target date funds solve the problem of analysis paralysis by simply asking investors to pick a single fund that corresponds to their retirement date.
Target date funds—like traditional balanced mutual funds—also encourage investors to focus on their total return, not on the performance of individual asset classes. When you build a portfolio of multiple funds, it’s easy to be distracted when Canadian equities are up but emerging markets are down, or bonds are flagging while US equities are soaring. Investors can lose sight of the fact that diversified portfolios are supposed to work that way.
Some commentators—usually advisors who favour active strategies—even criticize target date funds for not allowing a manager to adjust the asset mix in response to market conditions. But as any Couch Potato knows, that’s precisely why they’re so valuable. The evidence is overwhelming that paying someone to make tactical shifts in your asset mix is likely to subtract value, not enhance your long-term returns.
Staying on target
Despite their appeal, however, there are a few things to watch for if you’re considering using a target date fund in your workplace plan:
Watch the risk level. The right asset allocation for you depends on more than just your planned retirement date. Two investors planning to quit work in 2025 don’t necessarily have the same comfort level with the ups and downs of the market.
Indeed, many target date funds seem overly aggressive to me. Vanguard’s new lineup, for example, sets its equity allocation at about 90% for anyone looking to retire later than 2040, which could include people now in their 40s. Very few investors are comfortable with an equity allocation that high.
If you’re a conservative investor, consider choosing a fund with an earlier target date if you would prefer less volatility.
Don’t assume they’re all the same. Target date funds from different providers can have quite different strategies. Consider the Fidelity ClearPath® 2035 Portfolio and the BlackRock LifePath 2035 Index Fund: while both hold roughly the same overall mix of equities and fixed income, the Fidelity fund has more than 37% in Canadian stocks while the BlackRock version includes only 20%.
Fidelity’s ClearPath offerings are also built from active funds, while BlackRock (who is the parent company of iShares ETFs) uses underlying index funds. Vanguard’s new Target Retirement Funds will also be built from a new family of pooled index funds designed for large institutions.
Be aware of costs. Target date funds are offered with the range of management fees: the primary factor is how much of the cost your employer is willing to bear. If you work for a big company with excellent benefits, the cost may be just a few basis points, but I’ve seen employees of small firms paying close to 2%. If the price tag is too high they only make sense if the company match is generous—and even then you should probably transfer the funds to a self-directed RRSP as soon as you’re eligible.
Are target date funds the optimal investment product? No, but they shouldn’t be compared to perfection. They should be compared against the most common alternatives: building poorly diversified portfolios of random funds, or even opting out of retirement plans altogether. Against that backdrop, a cookie-cutter solution looks pretty good to me.