How do you know if your investment selections are adequate? How do you maintain that adequacy throughout your entire 30-45 years of working? We find a lot of couples struggle with these decisions or frankly ignore it all together and it’s easy to see why - most of us have had little to no education on how to invest in what will likely be your biggest asset. One way the industry has helped alleviate this obstacle is by introducing target date funds.
WHAT IS A TARGET DATE FUND?
Target date funds first started in the early 1990s. The “target date” is simply the year you anticipate retiring, with the default often being the year you turn age 65 - or close to it. The concept behind target date funds is to provide greater simplicity for the everyday investor. Rather than selecting specific funds and establishing a specific asset allocation model within your retirement plan, the target date fund takes care of this for you.
Here’s how it works - the investment selections within a target date fund are more aggressive the longer away you are from your target date and those selections gradually become more conservative as you approach retirement. For example, as a 35 year old you may elect to invest your entire 401(k) or 403(b) plan into a 2050 target date fund (remember - age 65 is our default). As a 35 year old investor, the target date fund is likely to have an aggressive investment allocation, (such as 90% equity/10% bond) and by the time you reach your target date of 2050 or age 65 your allocation may be reduced to 40% equity/60% bond. This transition from greater equity exposure to greater bond exposure is called the “glidepath”.
Target date funds have made it easier for individuals to invest within their retirement accounts. It’s natural to see a large list of investment options, say to yourself, “I’ll focus on that later,” and completely forget about it. Target date funds make this decision process much easier. However, there are also setbacks of investing in target date funds as well such as not being customizable and being too cookie cutter. We all have different income needs, financial resources and goals in retirement. Does a predetermined portfolio really tailor to your specific situation for investing?
Let’s dive into the pros and cons of target date funds and determine what’s the best solution for your needs.
PROS OF TARGET DATE FUNDS:
Auto Enrollment
Target date funds have increased in popularity due to the auto-enrollment legislation called the Pension Protection Act of 2006. This legislation required a default investment selection for retirement plans such as 401(k)s. As we discussed earlier, the greatest benefit of target date funds is creating simplicity around investing for retirement.
Investment Selection
Target date funds are similar to Amazon. It’s one stop shopping for all your investment needs. The convenience of selecting one investment that assumes your time horizon is a tremendous benefit of investing your account in a target date fund. Target date funds are attractive to investors that do not wish to manage the investment selections within their 401(k). By forgoing investment selections, investors do not have to worry about customizing their asset allocation. Target date funds rebalance the portfolio at least annually, meaning you don’t have to make the changes yourself.
Professional Management
Not only are target date funds low maintenance, they are also professionally managed. Typically the fund is managed by a professional meaning that person or team will reallocate investments or reduce equity exposure as you get closer to retirement. Creating access to a low maintenance, professionally managed fund designed for your specific retirement date has increased employee participation in employer retirement plans over the years.
CONS OF TARGET DATE FUNDS:
Market Risk Reminder
In 2008, investors that held 2010 target date funds were under the assumption that their target date funds were not subject to the stock market plummeting as they were only 2 years from their target date. However, many of the target date funds still were allocated to 50% equities. With only 2 years until investors reached their target date, the fund was more aggressive than investors anticipated.
Inability for Customization
According to Marketwatch, 70% of US companies automatically enroll their employees into a 401(k) type plan, and 86% of these companies put people’s money by default into target date funds. Is this the best option? Say a 35 year old is rattled by short term market volatility and scared of investing in the stock market. Does a target date fund that’s aggressively allocated really suit this investor? Creating an asset allocation and selecting several funds within your retirement plan may be a better option than the default target date fund. By being able to truly customize your retirement account allocation to match your risk tolerance, you are in control of mitigating risk against market volatility.
We don’t all have the same income needs and financial resources, so investing in a broad target date fund may not be unique enough for your situation. For example, an investor in their 50s may need an annual average of 10% rate of return in order to reach retirement at 65. So what happens when their target date fund is projecting to return 5%? It’s situations like this that may require someone to customize their retirement account allocation instead of investing in a target date fund.
Fees and Expenses
Target date funds also have fees and expenses tied in to them. Some charge a sales load, expenses may be built within the fund, and there may be a management fee associated with it as well. Understanding the fees you are paying for a target date fund or any fund is important as an investor.
KNOWING WHAT’S RIGHT FOR YOU
You have to weigh your options: convenience or customization. Is having the convenience of your investments selected and rebalanced important? Or is having the customization of investments based on your unique situation?
There’s no doubt about it - having the option for target date funds have done investors a lot of good. Simply based on our personal and professional experience alone, I am sure that many of those who have selected target date funds are better off than leaving it in cash or making the decisions themselves.
However, there comes a time in a lot of investors' lives where they feel customization is what’s in their best interest going forward. So, where do you turn to for help when you are ready to make that step? We recommend getting advice from a financial professional. Many fee-only financial planners are willing to offer a second opinion at no cost.
As fee-only, fiduciary and CERTIFIED FINANCIAL PLANNER (™) professionals, we would love the opportunity to discuss how investing in target date funds within your retirement accounts impact your unique situation. Contact us to learn more.
- Dan
Disclaimer: This article is for informational purposes only and is not a recommendation of Fyooz Financial Planning, Natalie Slagle CFP®, or Daniel Slagle CFP®. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. Therefore, it should not be assumed that future performance of any specific security, investment product or investment strategy referenced in the article, either directly or indirectly, will be profitable or equal to the corresponding indicated performance level(s). No portion of the article shall be construed as a solicitation to buy or sell any specific security or investment product or to engage in any particular investment or financial planning strategy. Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have the effect of reducing the performance of an actual investment portfolio.
