Perspective: How to Choose a Target-Date Fund

Albert Einstein might have been thinking about target-date funds when he said that everything should be made as simple as possible, but not one bit simpler.

From one perspective, what could be easier for financial advisers and retirement plan sponsors? Target-date funds, also called lifecycle funds, make it possible to provide comprehensive, professionally managed investment strategies that are appropriate for almost any employee. And all employees have to do is choose a date in the future when they’re likely to retire.

But screening target-date funds is about as simple as explaining the theory of relativity. Few target-date funds are alike, and, though past performance is no guarantee of future results, most lack track records that provide a meaningful basis for comparison. It’s not surprising that many advisers and retirement plan sponsors are wrestling with the challenge of comparing the myriad of offerings.

Never miss a story — sign up for PLANADVISER newsletters to keep up on the latest retirement plan adviser news.

Based on our experience in providing time-based asset allocation solutions since 1995, here are some suggestions that we believe can help you and the plan sponsors you work with effectively evaluate target-date funds.

  • Understand the rationale for the glide path. The glide path is a map of how a fund’s asset allocation changes over time. It is also the key to understanding a fund’s investment philosophy and process. The importance of understanding how a glide path was developed and how it is managed and rebalanced goes beyond due diligence. A clear, intuitively appealing process that you can explain to clients with conviction can dramatically increase the potential that they will stick with your advice and enjoy the long-term benefits of a well-crafted target-date strategy.
  • Assess the underlying investments. How a glide path is implemented is as important as how it was developed. Most target-date funds use mutual funds as the underlying investments, which makes it fairly straightforward, although time consuming, to assess how closely a fund will replicate a glide path that you find appropriate. Consider factors such as tracking error, style drift, and risk metrics with longer time frames in mind.
  • Don’t rely solely on Modern Portfolio Theory. Statistics such as standard deviation and alpha are powerful tools, but they are based on short time frames. Standard deviation, for example, is typically calculated using monthly variance. As valid as such observations may be for short time frames, they do not necessarily hold true for longer periods. Given that target-date funds are inherently long-term strategies, MPT metrics used in isolation can be misleading because they do not consider how the relative risk of asset classes changes over time. They also can mask the risk of losing the positive returns that prudent equity allocations historically have produced over time frames of 10 years and longer. For example, in 16 of the past 57 calendar years through 2006, small-cap stocks produced negative returns, including a 30.9% decline in 1973. For investors needing cash within a year, such an investment would be quite risky, and a cash account would be more prudent. However, on a rolling 10-year basis, the risk of loss is reduced significantly. In fact, from 1950 through 2006, small-caps’ worst 10-calendar-year return — the period ending 1974 — was a positive 3.2% average annual return. Even more striking, in their worst 20-calendar-year period since 1950, small-caps produced a positive 8.2% average annual return, which is better than the best 20-calendar-year average annual return for Treasury bills of 7.7%, which occurred over the high-interest-rate period ending 1991.Clearly, the risk-reward relationships that make MPT a powerful tool do not anticipate the time frames inherent in target-date strategies.

See the other columns in this series: Cost and Concentration: Pros or Cons in Target-Dates? and Why Plans That Need Target-Date QDIAs Need You

Gary Terpening is Research Analyst, SeligmanTargetHorizon ETF Portfolios of Seligman Advisors, Inc. The Funds are distributed by Seligman Advisors, Inc.

Diversification does not ensure a profit or protect against loss in a declining market.

The indices are comprised of the following: US Small-Company Stocks: Russell 2000 (1979 – 2006) and Ibbotson Small Stock Index (1950 – 1978); US Large-Company Stocks: Standard & Poor’s 500 Stock Price Index (S&P 500); Investment Grade Fixed Income: Lehman Brothers Government/Credit Bond Index (1973 – 2006), Estimated as the Citigroup High Grade Corporate Index (1969 – 1972); and Ibbotson Long Term Corporate Bonds estimate (1950 – 1968); US Government Bonds: Lehman Brothers Government Bond Index (1973 – 2006) and Ibbotson Long-Term Government Bond Index (1950 – 1972). Treasury Bills: Ibbotson One Bill Portfolio.

The stocks of smaller companies may be subject to above-average market-price fluctuations. There are specific risks associated with global investing, such as currency fluctuations, foreign taxation, differences in financial reporting practices, and rapid changes in political and economic conditions. Because of the special risks involved with investing in securities of emerging market companies, investing in such companies should be considered speculative and not appropriate for individuals who require safety of principal or stable income from their investments. Investments in real estate securities (e.g., REITs) may be subject to specific risks, such as risks to general and local economic conditions, and risks related to individual properties. Bonds are subject to interest-rate risk, credit risk, prepayment risk, and market risk.

The views and opinions expressed are those of the commentator as of November 2007, are provided for general information only, and do not constitute specific tax, legal, or investment advice to any person. Opinions, estimates, and forecasts may be changed without notice.

Investments by the Funds of Seligman TargetHorizon ETF Portfolios in ETFs involve risk, including the risk of loss of principal. An investor in a Fund will indirectly bear the operating expenses of the ETFs in which the Fund invests. The total expenses borne by the investor will be higher than if he or she invested directly in the ETFs, and the returns may therefore be lower. To the extent that a Fund has a substantial percentage of its assets exposed to an industry or sector through its investment in ETFs, the Fund’s performance may be negatively affected if that industry or sector falls out of favor.

You should consider the investment objectives, risks, charges, and expenses of Seligman TargetHorizon ETF Portfolios carefully before investing. A prospectus containing information about the Funds (including their investment objectives, risks, charges, expenses, and other information about the Funds) may be obtained by contacting Seligman Advisors, Inc. at 800-221-2783. The prospectus should be read carefully before investing in the Funds. The Funds are distributed by Seligman Advisors, Inc.