Retirement requires better aim with target date funds

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(MoneyWatch) Welcome back to my second post that examines how you can best hit the mark with target date funds (TDFs) as you approach retirement. (My last post provided background on TDFs and advised that you look beyond the target retirement year when selecting a fund that works best for your goals and circumstances. You may want to read that piece to more clearly understand this post.)

Challenges with target date funds

Target date funds require particular attention in the five to 10 years preceding your retirement or if you terminate employment well before retirement. According to a 2011 survey report from AonHewitt, 42 percent of terminating employees receive a cash distribution from their 401(k) plan, 29 percent roll it over to an IRA and only 29 percent leave their accounts in their former employer's plan.

Cashing out your account at termination or retirement can defeat the purpose of a TDF, since many are designed with the assumption that you'll stay invested in the TDF throughout your career and during retirement. If you cash out upon termination or retirement, your investing time horizon is a lot shorter than the horizon assumed by the designers of the TDF. You might also be cashing in at a bad time, say, when the stock market has recently dropped.

What should you do when you terminate employment?

If you terminate employment well before retirement, you'll have an important decision to make regarding your TDF. Remember, the target date fund was designed with the thought in mind that you'd remain invested in the funds until you retire and perhaps beyond. Resist the temptation to cash it out; investigate whether you can remain invested in your TDF with the 401(k) plan of your former employer. According to federal law, your employer can't cash you out if your balance is $5,000 or higher, and many plans allow you to remain invested with smaller amounts.

If you decide to withdraw your account from your 401(k) plan when you terminate employment, you should roll your account over to an IRA and keep it invested for retirement. You'll be best served if you line up your new investments before triggering the payment. Take the time to investigate investments that would appropriately replace your existing TDF; be sure to look closely at your new fund's asset allocation and level of fees.

"Glide path" is crucial for retirees

A very important feature of a target date fund is the so-called glide path it uses to shift to more conservative investments as you age. In the mutual fund industry, there are significant differences between the allocations to stocks at retirement and how rapidly the funds transition to more conservative investments. For example, according to a report from State Farm, at retirement the allocation to stocks among various TDFs ranges from 20 percent to 66 percent. (This report contains a helpful graph that shows the variances in the glide paths among different funds, including TDF industry leaders Fidelity, T. Rowe Price, and Vanguard.)

One concept to understand about glide paths is the "to" versus "through" method of shifting the asset allocation of a particular target date fund. TDFs that use the "through" method will continue shifting to conservative investments after the target year, whereas "to" TDFs stop shifting assets at the target date. Some people believe that "to" TDFs are more conservative than "through" TDFs, but that's not necessarily the case. A "to" TDF can still finish at a high allocation to stocks, so it's critical that you investigate your particular TDF and make sure you're comfortable with its allocation to stocks.

What you need to do as you approach retirement

Ideally, five to 10 years before retirement, you should begin thinking about how you'll use your retirement savings to generate a retirement paycheck. Why? Because the type of retirement income generator that you'll use should have a significant influence on the glide path that best fits your circumstances.

"Through" target date funds work best when you decide to use systematic withdrawals to generate a retirement paycheck. With systematic withdrawals, you remain invested in a portfolio balanced between stocks and bonds, and you cautiously withdraw principal with the goal of making your money last for the rest of your life. With most systematic withdrawal schemes, 40 to 60 percent of assets are devoted to stocks at retirement, which aligns with the glide paths of many TDFs.

"To" target date funds that end with a low allocation to stocks -- say 30 percent or lower -- are appropriate when you decide to buy an immediate annuity upon retirement or shortly thereafter. If you have a significant allocation to bonds in the years immediately before your retirement, your bond investments will move in the same direction as annuity purchase rates, since both are influenced by the level of interest rates. This strategy will help enable a smooth transition from investing to generating retirement income.

You might also consider a "to" TDF with a low allocation to stocks if you plan to cash out your entire retirement savings at retirement, for the same reasons mentioned above regarding termination of employment before retirement.

The bottom line? Don't blindly stay with a given TDF right up through retirement. You'll need better aim, so choose the TDF with the allocation between stocks and bonds that's right for your goals and circumstances, including the method you'll use to generate retirement income. Remember, you don't need to select a TDF with the same year that you actually retire. If the TDF family offered in your 401(k) plan doesn't mesh with your goals, you may need to use other funds in your plan.

Choose carefully, and you'll be on your way to creating the retirement you want.

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    Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck and Recession-Proof Your Retirement Years.

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