Understand the Facts About Target-Date Funds
December 02, 2013During a recent series of retirement workshops geared toward early and mid-career employees, I received numerous questions regarding the role of target date funds in their 401(k). This brought up an interesting discussion about hands-on vs. hands-off investing options. Target-date funds are supposed to provide simple solutions for people seeking an all-in-one fund that is diversified. Yet, a tremendous amount of confusion surrounds these seemingly basic asset allocation tools. Furthermore, not all target date funds are created equal so it’s essential to first look under the hood if target date funds are a part of your investment plan for retirement.
If you are investing in anything, be sure you understand how the investment works at least on a basic level. This key principle is often ignored, especially among people saving for retirement through target-date funds. The reality is that most investors these days do not appear to know how target-date funds actually work. For example, a recent SEC survey identified some serious concerns about investor knowledge regarding these investments. Less than 30% of respondents to the SEC survey correctly identified that the year in the target fund name itself (e.g., 2020) refers to an anticipated retirement date.
So what exactly are target-date funds? What’s their big appeal? And most importantly, are they a good fit for you and your retirement accounts?
Target-date funds are ideal for hands-off investors. They include a mix of different asset classes such as stocks, bonds, and cash equivalents that are put together with retirement savings in mind. They do this with a “glide path” that takes you from aggressive when you’re younger to relatively conservative as you approach age 65 by investing a smaller portion of your money in stocks and more in bonds and cash each year. That’s because if you are a younger investor, you have time on your side and an easier time dealing with the expected volatility of a portfolio more heavily weighted in stocks so your portfolio will be more aggressive.
Target date funds then automatically become increasingly conservative as you get closer to the target retirement date, such as 2020 or 2030. This is not a bad investment option to consider if you are seeking the convenience of a one stop shopping experience. This convenience means that once you determine the most appropriate fund for you personally, you can essentially “set it and forget it” by picking the fund that matches when you plan on leaving the workforce.
When people don’t understand this, they tend to invest in other funds in addition to the target date fund. The problem is that since the asset allocation decisions and re-balancing strategies are determined by the fund’s management team, adding other funds is not only unnecessary but can actually defeat the whole purpose of the target date fund by throwing off the mix of investments. That can mean taking more risk than you should or being too conservative to get the growth you need.
Target-date funds do not eliminate investment risk. Like most investments in stock and bond markets, target-date mutual funds provide absolutely no guarantee of performance or income during retirement. One of the most disconcerting aspects of the SEC study was that it revealed that 30% thought that target-date funds actually provide guaranteed income in retirement. They do not. Thinking otherwise can cause you to take a lot more risk than you normally would.
Investors in target-date funds still must understand their personal risk tolerance. You shouldn’t just blindly accept a risk tolerance approach based solely on your expected year of retirement. Taking the time to understand your personal tolerance for risk and the strategy that best fits your age, goals, and time horizon should remain a key part of your annual financial checklist. (To find yours, you can complete the following investment risk tolerance quiz or our brief risk tolerance assessment.)
This is because even if you pick the target date fund that most corresponds to your retirement date, the asset allocation guidelines for your particular risk tolerance may be very different. Not everyone retiring in 2025 needs to have 70% of their retirement portfolio in stocks. For others, 70% may be too little stock exposure. One simple solution is to choose a fund with an earlier target retirement date than your actual retirement date if you’re more conservative or a later date if you’re more aggressive.
Target date funds aren’t for everyone. Finally, you may not like the mix of investments in the target date funds, how that mix changes over time (known as the “glide path”), or the fees that the funds charge. If you prefer to manage your own investments or have a personal investment adviser, a target date fund may not be right for you at all. The same is true if you want to stay at a certain level of risk. In that case, you can invest in a balanced fund that matches your risk tolerance or put together a customized portfolio and re-balance it yourself at least once a year.
With all of the uncertainty surrounding investment options and with the growing realization that the burden of saving for retirement most likely rests on your own shoulders, it is comforting to know that vehicles like target-date funds are around to help simplify the process of saving for your retirement. But if you contribute to a target-date fund, it is always wise to take the time to fully understand what you are investing in. After all, simple doesn’t always mean safe.