Target date funds are seeing increasing popularity among investors. Many 401K plans and other work-sponsored retirement accounts now offer a variety of target date funds. Why are they becoming so popular? What do you need to know about these investment vehicles?
Target date funds help address a problem that many investors face. One of the challenges of using a 401K account or other self-directed investments is portfolio allocation and risk management. A common issue among 401K investors is a lack of understanding of the construction of their investment portfolio. A 2016 study indicates that 40% of Americans do not understand their investment allocation. Please do not be one of these people!
Target Date Funds and Asset Allocation
The issue that target date funds really help to address is built-in risk management. As you get older and approach retirement, it is very likely that your investment needs have changed. When you are younger, you are probably more likely to take risk with your money, knowing that you have time to deal with the ups and downs of the stock market. As you approach retirement, you should be thinking more about wealth preservation. However, what if you are invested in an aggressive mutual fund that is designed solely for growth? You could be taking an excess amount of risk. Unfortunately, many people do not realize this until they deal with a severe downturn in the stock market. Naturally, this usually happens right as they are planning on retirement.
Target date funds are designed to become more conservative as they mature. The beauty of a target date fund is the simplicity. All you have to do is pick the year you plan on retiring. Over the years, the fund will automatically change the allocation from more risk to less risky investments. What may start as a 90% – 10% allocation of stocks and bonds may become a 50% – 50% allocation as the target date approaches. If I select a 2030 Target Date Fund, it will be more conservative than a 2060 Target Date Fund. The fund with the longer time horizon will take more risk to allow for more potential growth.
Target Date Funds and Risk Management
Like any other type of mutual fund, there are pros and cons to consider. A target date fund does offer some wonderful advantages for investors. In 401K plans with limited selections, it may end up being the best choice to meet your financial goals and risk tolerance. The risk management portion is very important to consider. Unfortunately, many people maintain excess risk in their retirement portfolios. I love it when people automate their retirement savings, but make sure it’s not “out of sight, out of mind”. It is vitally important that you clearly understand the amount of risk you are taking with all of your investments.
Without the automation of a target date fund, it is important to make sure you are comfortable with the allocation in your portfolio. If you are older, are you still comfortable having most of your investments in stocks? Do you have enough money saved to comfortably fund the retirement you desire? What would happen if the stock market took a nose dive for several years? Would that impact your ability to retire? If you have a heavy concentration of investments in company stock, do you fully understand the risk involved? The questions surrounding risk and asset allocation are critical to consider.
Target Date Funds – Pros
Broad Diversification – Target date funds are made up out of a variety of stock and bond investments. Many of the target date funds follow a variety of stock and bond index funds. This helps bring massive diversification into the portfolio. Diversification is a key component to good risk management.
Professional Allocation and Re-balancing – A target date fund management is done by professional money managers. They construct the fund to meet the allocation objectives. As the years go by, they reduce the amount of risk in the portfolio by changing the percentage of stocks and bonds. The manager automatically re-balances the portfolio on a regular basis, so the investors do not have to.
Low cost – Because the fund is managed under the same consistent guidelines, the fund company can offer these funds at low cost. Low cost is always in the best interest of the investors. Most people lose money through excessive fees and excessive trading costs. The built-in nature of the target date fund makes it extremely easy to minimize these risks. There is no need for investors to re-balance or sell off assets.
Conservative Nature – This is a pro for many investors. It protects them from taking too much risk in their portfolio. A target date fund is conservative by nature, and becomes more conservative as it matures.
Target Date Funds – Cons
Conservative Returns – One of the cons of a target date fund is that it might be too conservative for some investors. Since the fund automatically re-balances as it matures, it may not meet the needs of all people. You might be at a point in your life where you are willing and able to take more risk than the target fund is designed to do. A target date fund may not come near the return that you may be able to achieve with a more aggressive portfolio. This is something each investor must consider.
They Still Contain Risk – Some people falsely assume that when the fund approaches the target date, the risk is virtually eliminated. This is not true. For example, the current allocation of the Vanguard Target Retirement 2020 Fund is still approximately 50% – 50% stocks and bonds. While many people are comfortable with this amount of risk, you might be at a point where you require less risk in your portfolio.
Some Funds Have Higher Fees Than Others – Not all target date funds are created equal. While companies like Vanguard maintain low fees, you may not have access to them in your 401K or 403B. You might have target date funds from another company that charges higher fees. Make sure you are very clear on the fund construction and how much the fees are. These are important details to ensure you get an adequate return on your money.
Target Date Funds – See If They Are a Fit for You
Many investors enjoy the benefits that a target date fund has to offer. You have to decide if a target date fund is right for you. Remember, everything comes down to your financial goals. What do you want to accomplish with your money? What do you want that money to do for you? If the fund objectives meet your goals and your risk tolerance, it is well worth investigating. Target date funds take a lot of the work out of the equation for investors. With built-in diversification and re-balancing, they do offer some great advantages. Like anything else to do with your money, make sure you carefully consider the pros and cons.