Target-date funds sound like they make retirement simple.
Plunk one or more into your 401(k) or IRA account, choose a retirement date and watch your portfolio grow, bringing you to the financial nirvana every retiree craves.
These asset classes can include domestic and international stocks, U.S. Treasury and high quality corporate bonds and as the target date nears, inflation-protected bonds or "TIPS." The fund automatically rebalances the asset allocation over time to make it more conservative as your retirement date nears.
As an example let's compare two target-date funds from the same family: Vanguard. We'll choose one fund dated 2015, the other dated 2030. The 2015 fund is right for a person with three or four years left in the work force, say someone around 60 years old. Currently the 2015 fund is 56.7% invested in stocks and 43.2% in bonds.
In contrast, the 2030 fund, which is appropriate to someone in the 40 to 45 age demographic, now has a mixture of 80.3 stocks and 19.6% bonds. The remainder of both funds (less than 1% is allocated to cash).
A selling point of target-date funds is they give you a pre-made, age-appropriate, professionally managed and diversified portfolio. Because asset allocations are determined for you, these funds can be just right for new investors unsure about how to build a portfolio. The funds are also designed for those individuals who want to "invest and forget" and not have to closely monitor the market fluctuations.
But targeted funds are not for everybody.
Here are some points to consider:
- Retirement target, not risk tolerance: The asset allocation of a target-date fund is based on your selected retirement date. As a result, the assets fund managers choose don't take into account your individual risk tolerance.
You may end up with a portfolio that contains much riskier investments than you're comfortable with. Or, conversely one that's too conservative to reach your retirement goals. Before you invest, check the fund's current holdings and whether you're comfortable with the risk they expose you to.
- Fees: Although many target-date funds are comprised of low fee index funds, some brokerage companies and 401(k) providers charge a hefty fee for you to invest. Before you invest, check the costs of several competing providers to make sure you are not overpaying on expense fees. T. Rowe Price, Vanguard, iShares, Fidelity and others all offer their own target-date funds.
- Taxes: Along with fees, taxes are an important aspect to consider. Every time your portfolio is rebalanced, it is likely to alter your taxable capital gains distributions. Therefore, you almost always want to hold target-date funds in a tax-deferred account.
- Contributions: Although much of the asset allocation work is done for you, you still have to determine how much money you're willing to put into the fund. Even an optimally performing portfolio won't turn into a retirement cash cow if you don't contribute enough over the years.
On the other hand, if you put in too much cash, you could risk losing your fortune in a poor performing fund. As a result, target-date funds may be one of the cornerstones of your retirement planning, but it shouldn't be the only one.
- Monitoring: Before you select any kind of targeted fund check its performance using a website such as Morningstar. Aim to find a fund which is at least in the upper half of its peer group.
Every so often make sure your fund's performance isn't sliding. You'll want to monitor it against benchmarks such as the S&P 500 and/or other target-date funds. It's also wise to keep up with changes such as increases to the fund's expense ratio, or unplanned shifts in asset allocation and investing strategy. These changes will affect your ultimate investment dollars.
[Maximize your 401(k)'s performance with 5 Surprisingly Easy Ways to Overhaul Your 401(k)]
- Inflation: While scaling back on risk as you age is considered good money management, a high proportion of inflation-beating growth stocks may be needed to meet retirement goals.
Target-date funds typically decrease stock allocation to less than 20% in the final years before they mature. Yet, some financial planners argue stock allocation should be at least 50% or higher during this time to meet growth targets. Again the solution is to make a target-date fund one part of your retirement planning strategy and not the entire solution.
The Investing Answer: Target-date funds can help bring you closer to the financial freedom you dream of. But they are not a panacea. Being aware of their uses and potential drawbacks should help you evaluate if they belong in your retirement plan and how big a role they should have.
[Want to learn how to build your own simple portfolio? Check out our guide: The Lazy Man's Retirement Portfolio]