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Target-Date Retirement Funds: Watch Out for the Flaws

You've heard about target maturity funds. But is it a good idea to jump into them?

Several traditional mutual fund companies like T. Rowe Price have created them in the last few years, as have other big fund companies like Vanguard, Franklin Resources (BEN - Get Report) and Charles Schwab (SCHW - Get Report).

Recently TD Ameritrade created a target-date family with five products under the name TDAX Independence Exchange Traded Funds.

The concept is straightforward: An investor buys the fund that comes closest to maturing at his intended retirement date. As the fund moves closer to maturity, it automatically reduces equity exposure in favor of fixed income exposure per a predetermined schedule.

Obviously, as people get older, it makes sense to lean more conservatively. A 35-year-old investor has more working years to recover from a serious decline in the equity market than a 65-year-old investor.

For example, the TDAX Independence 2040 ETF (TDV) is currently 97% equities and 3% fixed income, while the TDAX Independence 2020 ETF (TDH) is 67% equities and 33% fixed income. In addition to these two, there is also a 2010 ETF (TDD) that is 33% equities 67% fixed income, a 2030 ETF (TDN) that is 88%/12%, and the In-Target ETF (TDX) for someone who is already retired, which is allocated 11%/89%.

In theory, a fund with your target date could be the only thing in your brokerage account.

All of this is quite reasonable. Unfortunately, it is flawed for at least two reasons. Anyone wishing to use this type of fund as a building block for retirement has to deconstruct the flaws before proceeding.

By far the biggest issue is the strategic ignoring of inflation upon retirement. Looking out over the next 15 years, your expenses could increase another 40% to 50%, and maybe even more. In fact, inflation is a bigger enemy to retirement plans than market volatility.

A 60-year-old retiring today and putting it all into TDX is very unlikely to keep up with normal inflation over the next 15 years with 11% in equities and 89% in bonds. What if this 60-year-old retiree's parents are 90, still alive and healthy? That means the 60-year-old needs to plan on his nest egg providing enough income for at least 30 years -- more likely, 40 years.

We are currently in a period where stocks have had a violent 10-year round trip to nowhere. Still, $100,000 put into the S&P 500 20 years ago is now valued at $526,717, and that doesn't look so bad.

I am not making an argument for 100% equities -- far from it. Investors each have their own tolerance for equity-market volatility and must allocate accordingly. However, the idea that "11% equities" is appropriate for someone embarking on retirement is potentially ruinous.

A lesser issue is that, whatever your target for equities at times (like over the last couple of months), it makes sense to be underweight at least a little versus your target. Conversely, there are other times where it makes sense to be overweight a little.

This obviously requires some active decision making that will be right for some folks and not right for others.
At the time of publication, Nusbaum had no positions in the holdings mentioned, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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