Most of us want to navigate our way to a comfortable retirement, but it can be tricky finding the right road-map. Even when you’re effectively saving, what’s the best way to get from here to there? How can you make your money work as hard as possible to provide security (and fun!) when you stop working?
Investing in your company’s retirement plan is a great start. Once you sign up, though, you still have to pick the best investment for your money. That can be an overwhelming choice if you’re new to investing. Stocks vs bonds, large cap vs small cap, growth vs value funds…You have so many decisions to make.
The people who put together your investment choices know it can be overwhelming, and they’ve set up an easy option: the target-date fund. As long as you have a rough idea of when you want to retire, these funds supposedly make it easy to get you there.
But do target-date funds really deliver on that promise?
Like so many other things, it depends.
This post has been written by Emily Jividen, an excellent writer in the personal finance arena.
Target Date Funds Explained
Target date funds are mutual funds. They invest in a combination of stock and bond funds. What makes them target-date oriented is that they adjust the mix of stocks and bonds over time to reduce your investment risk as you move closer to your retirement date.
When you’re young, you have time to recover from market setbacks. So if you are far away from your target retirement date, your fund will carry a high amount of risk. If the risk pays off, you’ll make a lot more money than you would with safer investments. During market pullbacks, your long time horizon means your investments will probably recover eventually, stronger than before.
As you get closer to retirement, though, the target-date fund managers rebalance the portfolio so your investment is less risky. They’ll have more bonds and fewer stocks. Your investment will still grow, but not at the rates you could expect from more stock-heavy investments. If the market falters, your bond-heavy retirement funds won’t lose as much value and you’ll still be on track to retire.
Easy peasy, right? That’s why most 401(k) enrollment books put the target-date funds first. They make up 25% of 401(k) investments, and, according to Seeking Alpha, experts expect that percentage to double by 2020.
What’s the Good?
When you’re new to investing, having an easy option can make your beginning feel less intimidating. For a lot of people, the target-date funds make a good first investment because they reduce the number of decisions they need to make. One investment idea can take you from 25 to 65 without you ever missing a beat.
That’s really powerful.. Even if you change investments later, that comfort level that can make it much easier to make the first step and to begin learning the power of saving, investing and compounding.
Even if you aren’t new to investing, the rebalancing factor of target-date funds is appealing. Most of us do need to reduce the amount of risk we take as we get closer to our retirement, but it can be hard to adjust your investment mix over time.
If you pick your own mix, you have to decide:
- which funds to sell
- when to sell them
- how many shares to sell
- which funds to buy
- when to buy
- how many shares to buy
That’s a lot of decisions to make, and most investors have trouble with them!! They either forget to make them or make them based on emotions rather than a plan. Screw those decisions up, though, and you can end up with investments that are much riskier (or safer) than you want them to be. A target-date fund eliminates all those decisions and lets a fund manager make the adjustments in accordance with the fund’s guidelines.
So What’s the Bad?
Not all target-date funds are created equally, and they won’t all perform the same.
Target date funds are generally made up of multiple mutual funds. Each of the component funds has its own fee structure, which gets passed along to the investor. Plus, each target date fund will have administrative costs of its own to pass along.
Some of them can be pretty darn expensive, particularly compared to a good index fund. The difference between a 1% fee and a 0.2% fee is 8 cents for every dollar invested! Your account doesn’t have to get very big before higher fees start making a notable difference in your returns.
Not all target-date funds pick the best mix of funds for investors, either. Some mutual fund companies will stock their target-date funds with poorer performing funds to shore up sales.
Plus, even a well-managed target-date fund is a “one size fits all” solution.
Like a lot of things that are supposed to fit everyone, they may not fit you, especially if:
- Your risk tolerance is different than age alone would indicate. If health or technological disruption may compromise your ability to work in the future, you may need to take less risk.
- You have other investments that change your asset mix, like an IRA or brokerage account.
- You have a good investment strategy to follow and other investments fit it better.
Are They Right For You?
Target date funds can be a good investment, but that’s still going to depend on your choices and situation. Regardless of which investment choice you make, you’re going to have to do your due diligence.
Like any other investment choice, though, you need to investigate the fund a little bit. Check the fee structure and the returns. How do they compare to similar funds? While past performance never guarantees future returns, you’ll still want to steer clear of historically under-performing funds.
But if you don’t like the fund, you can always choose another approach.
You can even do a DIY version by picking 2 broad low-fee funds: one stock, one bond. Each year, you could re-balance the fund so that your bond exposure percentage equals your age. At 30, you’d be 30% in bonds, 70% in stocks. The next year, you’d have increased your bond percentage slightly.to 31% and the stocks to 69%. (Derek’s note: “For my stock exposure, I use the formula, 120 minus my age. So for me, at age 32, I have a stock allocation of 88%, and 12% bonds.)
If the fund’s solid, look at it from your personal situation. Many target-date funds are solid choices.
While “one size fits all” solutions never quite fit everyone, they do work for a lot of people. Only you can decide if a target-date fund is right for you and your retirement plan.
Do you use target date funds for your retirement?
My name is Derek, and I have my Bachelors Degree in Finance from Grand Valley State University. After graduation, I was not able to find a job that fully utilized my degree, but I still had a passion for Finance! So, I decided to focus my passion in the stock market. I studied Cash Flows, Balance Sheets, and Income Statements, put some money into the market and saw a good return on my investment. As satisfying as this was, I still felt that something was missing. I have a passion for Finance, but I also have a passion for people. If you have a willingness to learn, I will continue to teach.