Life-cycle (a.k.a. target-date) funds haven’t exactly dominated industry sales statistics. But these investment instruments do have their supporters.

Target-date funds (TDFs) hold about $5.4 billion in assets under management in total, according to Frank Hracs, chief economist, with Toronto-based Credo Consulting Inc. Hracs, who does insightful work on investment fund flows, also points to the “mellowing” of TDF demand. Yet, every time I’m asked to review a list of group pension options – only partially captured by retail fund data – the list is full of TDFs. These funds, often the default option in group pensions, present unique suitability and compliance concerns that should be top of mind.

TDFs are a simplistic solution driven primarily by a single time horizon – just one of several factors that should drive product selection and portfolio construction. Although TDFs often are employed in different ways, keeping a client in a TDF portfolio that remains appropriate to achieve stated goals can be a real challenge.

I plugged in my age and hypothetical retirement date (in 15 years) into one TDF sponsor’s calculator. The result placed me in a starting portfolio of 64% stocks and 36% bonds.

Within six years, it would have me holding less than half in stocks. And by retirement, I’d have about one-third in stocks, which would change into a payout fund. This tool does not consider age at retirement.

However, there’s a big difference between a 58-year-old retiree and one who is 68 years of age, for example. Different retirement ages suggest different lengths of time during which cash flow is required. This affects withdrawal sustainability and the rate of return required to support planned withdrawals directly.

A financial advisor would need to monitor TDF asset mix changes and ensure that the product remains suitable for a client, from both the risk and goals perspectives.

Even an income-payout product with a target date runs into potential suitability issues. These payout TDFs usually don’t meet the requirements of clients who need indexed cash flow. (Few stand-alone products will.)

I recently examined cash flows paid out by one of the better performing, longer-dated TDFs over the past 6.5 years.

That fund has paid out the equivalent of about 6% a year in the form of cash distributions. This TDF’s net asset value is about 10% lower than it was when the fund started – quite good, given that it launched in 2007.

But there are two problems.

The first is that this TDF’s cash flow fell well short of providing a modestly rising cash-flow stream over its 6.5-year life – not great, but not terrible. But I estimate that future cash-flow shortages will be very significant, based upon comparing returns required to repeat previous cash flows with our firm’s return estimates (which are based on fundamentals, not a crystal ball).

I expect that this particular TDF will generate net returns of no more than 4% a year for the next several years – well below what’s required to kick out an indexed cash flow net of fees. And because most people require an increasing stream of cash flow, all such products raise suitability concerns.

Guaranteed TDFs present additional challenges. They hand investors an outcome resulting from a set of features designed to protect the guarantor (not the investor) first and foremost.

So, the next time you’re considering recommending a TDF, keep these investment and suitability challenges in mind. And consider a good (and relatively cheap) balanced fund as an alternative. It’s a simple solution that just might be better and more suitable.

Dan Hallett, CFA, CFP, is vice president and principal with Oakville, Ont.-based HighView Financial Group, which designs portfolio solutions for affluent families and institutions.

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