In recent years, target date funds have caught on as a popular way to invest. These funds are easy to use because they allow you to put your retirement investing on autopilot. However, these investments are far from perfect. You should really take a look at how they are composed and how they work before completely handing over the keys.
What is a Target Date Fund?
A target date fund is simply a “fund of funds” or a single fund that owns several other mutual funds. So, you can buy one fund (the target date fund) and end up owning multiple funds (the underlying funds that the target date fund owns). Target date funds typically own somewhere between five and 30 underlying funds, although they may invest in numerous individual issues instead of (or in addition to) holding mutual funds.
Why do these funds exist? They make investing easy. Most employees in a retirement plan are either unwilling or unable to build a diversified portfolio themselves, but they can have it done for them in a target date fund. Instead of building an investment mix by deciding how much should go into different asset classes (13% to large cap growth, 8% to small cap value, 4% to emerging markets, etc), a target date fund investor simply selects a desired level of risk. Does she want a high level of risk, very little risk, or something in between?
Technically, target date funds are built to manage investments over a certain time frame. In any target date fund, you’ll see a number that looks an awful lot like a year (2020, 2030, 2050, etc). That year is the fund’s target date – the year in which an investor in that fund is expected to retire. You might assume that this is the investor’s 65th birthday if the goal of the money is to fund retirement.
Bigger Number = Bigger Risk?
So, what is the difference between all of those target date funds – how does that 2020 a fund differ from the 2050 fund? A rule of thumb might help: the bigger the number, the bigger the risk. So, the 2050 fund carries more risk than the 2020 fund (it has more invested in the stock market). And that makes sense if you think about it, because the number refers to the year in which an investor in that fund might retire. The year 2050 is way off in the future, so it might take on more risk, whereas the year 2020 will arrive relatively soon. An investor who will retire relatively soon presumably wants less risk, all other things being equal (but they’re not always equal: see Rising interest rates pose issue for target-date mutual funds if you intend to be conservative).
What happens as time passes and we move from the year 2020 to the year 2050? You guessed it: the fund automatically gets more conservative, shifting money from stocks to bonds and cash. This is different from target risk funds, which are very similar (they’re diversified) but which do not change much over time.
Of course, this assumes that investors with longer time horizons are willing to take on more risk, which might not be true. It also assumes that every investor with the same birthday is interested in taking on the same amount of risk. This is where target date funds can be troublesome. If you’re a relatively young investor, and you don’t want to take much risk, you probably don’t want to use a target date fund that lines up with your 65th birthday. Note that you can use any fund you like (you can invest in the 2015 fund even if you won’t retire until the year 2050, for example). However, picking an off-year fund requires some work on your part. You have to look under the hood and see how much risk the fund takes at any given point, and then pick one that appeals to you.
Criticisms of Target Date Funds
While target date funds make it easy to diversify and reduce risk over time, you have to be careful when using them. As mentioned above, you may disagree with the target date fund’s creator on how much risk somebody should take at retirement (so you have to evaluate the investment mix for your self – is it the right mix of stocks, bonds, and cash? Keep in mind that target date funds differ among vendors, so if you understood and agreed with the approach used at Fund Company A, you have to start all over if you switch to Fund Company B.
Another problem with target date funds is the quality of underlying funds. Some mutual fund companies have been criticized for putting poor performers in their target date funds, because not many people pay attention to pieces that make up the target date fund. This practice has diminished some over time, but you should still evaluate the holdings in any target date fund that you’re considering. The fund should not only have the right mix of stocks, bonds, and cash. It should also be composed of decent underlying funds. It’s OK if the underlying funds are not the absolute best performers last quarter, but you really want to avoid any fund company that places poor performers in a target date fund.
Fees are also a concern for target date fund investors. Fees may be difficult to understand, and they might be slightly higher than you would pay if you built the same investment mix yourself. It’s up to you to decide whether or not it’s worth paying an additional fee to have somebody build a target date fund for you. Keep in mind that those funds are rebalanced on a daily basis as people add and remove money, and somebody has to go to the trouble of building the portfolio (hopefully they’re qualified to do so, they use sophisticated tools, and they end up doing a good job of it).
So, are target date funds right for you? If you’re the type of person who wants to have things automated, then some sort of asset allocation fund is probably a good idea (whether it’s a target date fund or a target risk fund). The fund managers might not do things exactly the way you would, but the tradeoff is that you get to spend your time and energy on other things.
If you don’t love how a target date fund is constructed, keep in mind that it’s possible to use target date funds as just one portion of your portfolio. Yes, they are designed to manage 100% of your money, but you can bend the rules a little bit. If, for example, you would like to invest more overseas than you see in a given target date fund, you can use two funds: you might invest 90% of your money in the target date fund, and the remaining 10% in a fund that invests exclusively overseas. In essence, you’re adding a few drops of hot sauce to your target date fund so that it suits your taste.
More Information on Target Date Funds:
- How to evaluate target-date funds
- Should You Trust Your Retirement To A Target Date Fund?
- Investor Bulletin: Target Date Retirement Funds
Photo credit: L. Marie