After my last article about reviewing your retirement plan, some people mentioned that they don’t need to worry because they are invested 100% in target date funds. While these are advertised as a simple solution, you may want to dig a little deeper to understand if they are the right solution for you.
What is a target date fund?
Target date funds are often thought of as a one-stop-shop for your retirement planning needs. Without getting too deeply into the weeds, essentially a plan participant buys a target date fund that closely corresponds to their retirement date. In other words, your fund options may include XYZ Target Date Fund 2040, XYZ Target Date Fund 2050, etc. If your plan is to retire at age 67 in 2048, you might choose the 2050 fund.
The fund you choose morphs over time, starting more aggressive (think more stocks) and becoming more conservative as you approach retirement. If you begin early enough, you may go from a 90% stock/10% bond portfolio to something closer to 40% stocks and the rest more conservative. Note too that retirement plans offering target date funds may use them as the default option when you first open an account.
Why use target date funds?
Target date funds are found in an increasing number of retirement plans; in fact, a recent research report by the Employee Benefit Research Institute noted that almost 87% of retirement plans offered target date funds for their participants.
Easy Diversification. Many target date funds split money between US and International stock and bond investments. One recent example showed 54% of assets in a US stock index fund with 36% in an international stock index fund, while the bond side totaled 7% in US bonds and the rest in international bonds. Plan participants don’t have to research funds or attempt to determine the percentage they want in each category.
Professional portfolio management. To determine the amount to invest in these categories, target date funds often utilize the most up-to-date research on portfolio management. In other words, they aren’t guessing that it should be 54% in US stocks instead of 74%.
Automatic rebalancing. Many financial professionals believe you should rebalance your portfolio regularly. This means that if you wanted to have 70% in stocks and discover it’s dropped to 60%, you either add new money to bring it back into balance or sell some of your other investments in the plan and invest that money into the underwater investment. With a target date fund, it’s all done for you.
Time savings. As you can imagine, picking the target date option that closely corresponds to your retirement is much easier than researching the other 20 investment options and determining if and how much to invest in each. Some people call target date funds a set it and forget it investment.
Disadvantages of target date funds
I noted above that target date funds are found in more and more retirement plans. In addition to providing an easy one-off decision, target date funds also lessen the potential for a company to be found negligent if their employees don’t reach retirement with a solid nest egg. Just having target date options means they have provided “leading-edge investments” for their participants; if the person chooses to go out on their own and not invest in these funds, the company may still be protected. The disadvantage here is two-fold; the company may not provide as much employee education if they rely on these funds, and – as you’ll see – target date funds aren’t perfect.
Does one size fit all? If you’re a reader of any financial blog or website, you will run across someone talking about determining your level of risk when investing. If you invest in a target date fund, you will have to be happy (or at least be able to sleep) with the level of risk that fund provides. So, if you’re 25 and choose the target date fund option with 90% of your investments in stocks, you have to be okay even in a year of market losses like we just experienced.
Think too of the money you’ll need at retirement. Lower-paid workers won’t have the same savings goals as higher-paid workers, so why should they be investing the same way? Similarly, someone may have an outside brokerage account while others may be investing only through their retirement plan. There are many variables of retirement planning that aren’t considered with target date funds.
Higher fees. Since different funds make up the one target date fund, fees can quickly mount. Many target date funds add another layer of fees for managing the fund as well. Often very low-priced funds end up costing you significantly more than if you were purchasing them on your own.
Perhaps too conservative? In recent years I’ve seen more people arguing that the glide path (the move from aggressive to conservative investments) becomes much too conservative at the stated end date. Remember that you are saving for years of retirement; this isn’t a race where you’re done at the finish line. You will need your retirement money to last for decades.
Some financial experts have suggested that if investing in a target date fund, you should purchase a fund dated a decade or so after you retire; using the above example of retiring in 2048, you might want to invest in the 2060 fund instead of the 2050 fund. The problem here is that you have to go into the inner workings of the fund to see how far to move your end date; if you wanted to become an expert on investments you probably wouldn’t be choosing target date funds in the first place.
Should you use a target date fund?
If the only way you’re going to invest is to use a target date fund, do it. Perhaps spend a few minutes trying to determine the proper end date for the fund, but participating in your retirement plan using one of these is definitely better than not participating at all.
However, if you want to do a little more research on your own, check under the hood to see what they are actually invested in. Are you comfortable with the fund options? Are the fees reasonable?
If you find a target fund with a portfolio you like but a high management fee, maybe you try to mimic it on your own. See if similar fund options are available in your retirement plan and invest your money in similar percentages to what you saw in the target fund. This won’t provide automatic rebalancing, but you can always check the percentages the following year and rebalance then.