Is a Target Date Fund Right for You?
Poring over investing portfolios isn't for everyone, so a target date fund can make sense. Take a look at some of these funds' pros and cons, and how you might incorporate one (or more) into your retirement plan.
What year do you want to retire? That single question is the concept behind target date funds, which are quickly growing in popularity.
Target date funds debuted in 1994 as a simple option for retirement savers. They are mutual funds, based on the year the saver plans to retire. Let’s say you are 50 years old and you plan to retire at age 65. You would select the target date fund for the year 2034 — or more likely 2035, as target date funds tend to come in multiples of five. The target date fund is actively managed for the rest of your life, rebalancing to adjust risk as you get older and closer to retirement.
As more retirement savers turn to this option, there are some pros and cons to keep in mind.
Pros of Target Date Funds
Conceptually, target date funds are great; they are a simple solution for people who either don’t want to deal with investing or who are intimidated by money. They are a good option for investors who are hands off and who wouldn’t rebalance their investments on their own. Target date funds are also good for DIY investors, because they are a more comprehensive strategy than picking on past performance, which is the way do-it-yourselfers often pick investments. They would pick the stocks that did well in the last quarter or year, which is not a successful strategy, because past performance does not necessarily indicate future growth.
Cons of Target Date Funds
Target date funds are not individualized for a person’s specific situation; they treat every person who will retire in a certain year as the same. However, every person is not the same. They have different income needs, lifestyles and resources in retirement. People should have an individualized income plan for retirement, and target date funds can’t do that.
Another con is that many people are not digging deep enough to find the best target date funds when it comes to internal costs, asset allocation and how the funds are managed. They are also not taking the time to figure out how to incorporate a target date fund into an overall retirement strategy. If you have a Roth or traditional IRA, how are the two complementing each other? Target date funds should be part of a complete retirement plan.
Things to Consider
To be truly diversified, retirement savers need to divvy up their money between the different types of asset classes — including liquid assets you can access at any time (like savings accounts and short-term CDs), growth assets (like mutual funds) and safe assets (longer-term CDs and possibly annuities).
Having said that, it’s also important to diversify your assets within each category. So, although target date funds have their advantages, putting 100% of your holdings in a single fund may be overdoing it. Anytime you’re putting all your eggs in one basket, it’s not a great solution.
When looking for ways to diversify your target date funds, consider diversifying your providers. Target date funds look different with each provider, for example Vanguard, Fidelity and T. Rowe Price. They are made up of different percentages of equities, and some are actively managed while others are entirely index funds. If you have the option, I recommend investing in target date funds for the same year from different providers.
Another simple way to diversify is to choose different years for your target date funds, for example 2045 and 2050. Theoretically, the 2050 target date fund would have higher risk. That means you would get better rewards during good years on Wall Street. You would also get a bigger sting during a bad year.
Investors should be looking at a target date fund’s prospectus and cost. You can go to a website like FINRA, plug in a fund and find out important information that’s easy to digest. I am very fee sensitive, so I like to look at the internal cost. There is good news on this front: Target date fund fees have been dropping in recent years. The average fee on a $10,000 investment is about $66. That’s compared with $103 in 2009. Is a fund actively managed or is it more passive? If a fund is actively managed, there is a money manager buying and selling equities in that fund. A passive fund will have more index funds and usually carries lower fees.
Some target date funds take on more risk than others. It’s important to research this to find out the level of risk you are taking on. There are great tools to analyze risk, like Riskalyze or AssetLock. A financial adviser can help by utilizing these tools to research the risk associated with each fund.
Generally, if a target date fund is being managed properly, it will have less risk as you approach the target date. You don’t want to take on more risk than you are comfortable with. That can make investors nervous when there’s a drop on Wall Street, and they end up selling at the wrong time.
You may also want to consider what companies and industries the target date fund is invested in. Some socially conscious investors may not want their money going into particular industries, like tobacco, alcohol or ammunition. If this is important to you, do your research on the fund. Dig into the fund’s holdings by doing some online research. You can find out which companies the fund is invested in and can shop around to find a target date fund that aligns with your objectives.
Younger generations are more interested in socially responsible investing, and we may see socially responsible target date funds in the near future.
Final Thoughts for Retirement Savers
If you are the type of investor who wants to “set it and forget it,” target date funds are a simple option you should explore. The bottom line: It’s important you commit to saving for your future. Keep putting money into your retirement accounts during both good times and bad. You won’t regret it.
About the Author
Founder & CEO, Drake and Associates
Tony Drake is a CERTIFIED FINANCIAL PLANNER™and the founder and CEO of Drake & Associates in Waukesha, Wis. Tony is an Investment Adviser Representative and has helped clients prepare for retirement for more than a decade. He hosts The Retirement Ready Radio Show on WTMJ Radio each week and is featured regularly on TV stations in Milwaukee. Tony is passionate about building strong relationships with his clients so he can help them build a strong plan for their retirement.