Financial advisers warn of potential 'land mine' in bond portion of target date funds


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The last time that target date funds failed to deliver on their promises to retirement investors was in 2008. The stock market crashed and many people who were near the end of their working careers suffered steep losses because fund managers had weighted their portfolios too heavily with stocks.

This time around, money managers at Fragasso Financial Advisors, Downtown, are concerned it could be the bond portion of such funds that pose the greatest risk if interest rates move up when people nearing retirement have shifted most of their assets to bonds.

"It's an interesting paradox," said Robert Fragasso, chairman and CEO. "People look at risk in the stock portion of their portfolio. They tend to think of bonds as the stable part.

"But there is a land mine that's sitting in the bond part of a target date fund, which they may be unaware of, and if they mindlessly employ it, it's going to blow up."

Conventional wisdom says investors should have a greater portion of bonds in their portfolio as they get closer to retirement -- which is exactly what target date funds are designed to do.

That advice, Mr. Fragasso said, could backfire if interest rates rise. And after years of historically low interest rates, interest rates have nowhere to go but up, which means bond prices at some point will go down.

Target date funds are one of the fastest growing segments of the mutual fund industry. According to the Washington, D.C.-based Investment Company Institute's 2013 fact book, there were 184 target date funds with $115 billion in assets in 2006. By 2012, there were 430 target date funds with $481 billion in assets.

Also known as life cycle funds and age-based funds, target date funds are managed mutual funds that let investors pick the year they want to retire -- 2015, 2020, 2025, etc. As the years go by, the funds automatically rebalance to be more heavily weighted with bonds and less invested in stocks as the target retirement date nears.

If the account owner's target date is 2020, the fund will automatically scale down the stock exposure and increase the bond exposure as the year 2020 draws near.

Many 2010 target date funds bombed in 2008, losing an average 20 percent of their value with one down nearly 40 percent because aggressive fund managers had overweighted the funds with stocks as they sought higher returns.

Daniel Dingus, president and chief operating officer at Fragasso, said target date funds appeal to retirement investors who don't really want to break a sweat planning their financial future.

"Target date funds in and of themselves aren't necessarily a bad thing," Mr. Dingus said. "It's when you're not educating plan participants on how they act and work. The industry has a bit of inertia and they are appealing to inertia."

With about $2 trillion in assets under management, The Vanguard Group, based in Malvern, Chester County, is one of the largest investment management companies in the U.S.

Catherine Gordon, a principal in the department that sets methodology for Vanguard's target date funds, said the company is aware of the impact that rising rates would have on bonds, but that doesn't change its long-term view because the funds contain both stocks and bonds.

For example, Ms. Gordon said, while the overall bond market was down 2 percent last year, the stock market was up 30 percent.

That meant the Target Retirement Income Fund -- the company's most conservative target date fund portfolio -- ended the year up 5.9 percent even though the fund is weighted with 70 percent bonds.

"We don't try to time interest rates," she said. "That is about as challenging as trying to time the stock market. People have been expecting rates to rise for years."

Most company 401(k) plans offer target date funds and they can be helpful to those who have never invested before because it gives them a basic asset allocation model to follow.

However, the people who should be paying closest attention to their target date funds are those who are about five years away from retirement and have 50 percent or more of their assets in bonds, said Dan Halle, vice president and manager of retirement plan advisers at Fragasso.

"They think they are OK," he said. "They think they are safe. But they really aren't because as interest rates rise, it will turn up the heat.

"Just like the frog in the pot, the frog doesn't realize what's happening because it's a slow process. But over the next 10 years, rates are going to rise. The heat will continue to increase and bond values are going to continue to come down."

Tim Grant: tgrant@post-gazette.com or 412-263-1591.


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