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Don't Throw the Baby Out With the Bathwater

Canada is a newer entrant to the target date marketplace, but the funds have quickly gained in popularity: nearly two-thirds of respondents to a recent poll expressed an interest in them.¹ But are they all they're cracked up to be? Target-date retirement funds, built as age-appropriate portfolios to help investors reach their retirement goals, have taken some heat lately for their lackluster performance during the global stock-market rout.

Funds designed for people who will reach retirement age in 2010—one year from now—fell by roughly 10 percent in 2008.² That's substantially less than the nearly 33 percent drop for all-equity mutual funds, but the typical 2010 fund includes large allocations to bonds…so why didn't it provide even greater protection?

It seems that target date funds suffered the same fate as many other investments in the latest downturn due to a widespread "failure of diversification." The ability to provide one-stop shopping in a single, well-diversified portfolio is one of the strong appeals of target date funds. But critics charge that during the worldwide financial meltdown diversification provided little cushion from losses because there has simply been nowhere to hide.

So what's an investor to do? Toss out target date funds and the diversification premise on which they're built? Not so fast. While some criticism may be fair, there's no need to go overboard.

Sure, during periods of extreme market stress, investments that aren't supposed to move in tandem tend to become more highly correlated. But most market observers would agree that the latest financial fiasco is a one in 100 year event—and that over the long haul diversification does work. And it's particularly important for Canada, given that three-quarters of the Canadian stock market is concentrated in three narrow sectors (energy, materials and financials).

Target date funds remain a viable option, too. In fact, some would argue they performed as advertised: younger investors with a more distant retirement date had more equity exposure while older investors less so. And for older investors, we must consider the alternative. According to a recent survey, about 40% of the 55- to 65-year-olds polled had 70% or more allocated to equities!³ If these investors had been invested in a target date fund, the impact of the market decline would have been significantly reduced.

Target date funds also have many other features to recommend them. Most investors find them easy to understand and they tend to promote better allocation and rebalancing decisions. For example, a study comparing risk-taking between investors in target-date funds and those not investing in them found heavy concentrations of either extremely conservative or extremely aggressive portfolios outside the target date funds. The target-date investors, on the other hand, had portfolios that were more consistent with sound long-term investment principles.4

Investors need to remember that however diversified, target-date funds still carry risk. In fact, many of us will hopefully live 30 years in retirement, so we need some equity risk to carry us well beyond 2010—something a "risk-free" investment isn't likely to do. Food for thought the next time you hear someone take aim at target date funds.

¹Benefits Canada's 2008 Survey of CAP Member
²Source: Gail Bebee, Study Shows that Life-Cycle Mutual Funds Failed to Preserve Retirement Savings, e-Newsletter Feb. 18,2009
³2008 Employee Benefits Research Institute
4Vanguard Group study of more than 1,300 401(k) investors

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