Target-Date Investment Funds
During the past twenty years target-date funds have become more popular with investors. Target-date investment funds also known as life-cycle, retirement, or age-based funds were first introduced in the early 1990s. Mutual funds offered instant diversification by pooling money and investing in the major asset classes (stocks, bonds, alternative investments, cash). This gave small investors access to a diversified portfolio of stocks, bonds, and other securities. Click here for my favorite target date funds.
As I mentioned in a previous article, over 90% of the gains from an investment portfolio comes from your asset allocation, or how much of each asset class you have. If you are close to retirement, you normally would have more conservative investments in your portfolio such as bonds and cash. If you are young, then you may have a larger allocation of stocks in your portfolio. People would invest in multiple mutual funds that represented the different asset classes to come up with their own asset allocation based on their personal goals, time horizon, and risk tolerance.
Target-date funds took it one step further by not only offering instant diversification, but also offering instant asset allocation. Target-date funds are based on dates. They typically contain a mix of stocks, bonds, and money-market funds that automatically adjust as you approach the date. For example, if you plan on retiring in 2030, then you would select a 2030 target-date fund. As you get closer to retirement, the fund automatically shifts and reallocates to a more conservative allocation. Target-date funds use a “glide path” to adjust the risk levels over time in order to meet the goal of investors’ starting to withdraw the money that particular year.
There are several benefits of target-date funds. It makes it easier and more convenient for people to invest without having to worry about adjusting or setting their own diversification and asset allocation. Instead of having to choose a number of investments and figure out the right amount of each one, you can choose a single fund and remove the guesswork. The only thing you have to do is pick a date. The funds also automatically rebalance when appropriate.
Some of the drawbacks are that expenses of target-date funds are generally higher than a fund that invests directly in stocks and bonds. They are also only based on year, not on the preferences of the investor. Even though the retirement year may be the same, workers may have different goals and risk tolerances. For some investors they can be generic and not personalized enough. Some funds are also “to” retirement while others are “through” retirement. There are currently over 600 target-date funds and although the retirement date may be the same, they each have their own fee structure, risk profile, and vary widely in their asset mix. It is difficult to compare them to one another or any one benchmark. You will have to do research to pick the right one. While there are some downsides, target-date funds are a simple way for many people to invest for retirement without having to do it themselves. Click here to see my favorite target date funds.
Investing for retirement can be complex. When deciding where to invest, you may need to make a variety of decisions, including how to balance the risk of losing money with the desire to increase your returns, keeping in mind that inflation may reduce the purchasing power of your savings and you or your spouse or partner may live longer in retirement than you expect. Recognizing this, a number of companies offer “target date retirement funds,” sometimes referred to as “target date funds” or “lifecycle funds.”
These funds are designed to make investing for retirement more convenient by automatically changing your investment mix or asset allocation over time. Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash investments. Once you select a target date fund, the managers of the fund make all the decisions about asset allocation.
Target date funds are often available through 401(k) plans. Some 401(k) plans use these funds as the default investment for plan participants who have not selected their investments under the plan. Both before and after investing in a target date fund, consider carefully whether the fund is right for you.
Evaluating a Target Date Retirement Fund
As with any investment, evaluate a target date fund carefully before investing. The target date may be a useful starting point in selecting a fund, but you should not rely solely on the date when choosing a fund or deciding to remain invested in one. You should consider the fund’s asset allocation over the whole life of the fund and at its most conservative investment mix, as well as the fund’s risk level, performance, and fees. This information is available in the fund’s prospectus.
As noted above, funds with the same target date may have different investment strategies and levels of risk. These variations may occur before the target date, and also at the target date and after it. Some target date funds may not reach their most conservative investment mix until 20 or 30 years after the target date, as shown in Example 1 below. Others may reach their most conservative investment mix at the target date or soon after, as shown in Example 2 below.
The fund in Example 1 holds 60% of its investments in stocks at the target date and 40% in bonds. The investment in stocks decreases until 25 years after the target date when it reaches an investment mix with 30% in stocks.
The fund in Example 2 holds 25% in stocks at the target date, and reaches its final investment mix with 20% in stocks five years later. The fund in Example 2 also holds cash investments (such as money market funds) as part of its mix.
Target date funds also may have different investment results and may charge different fees, even with the same target date. Often a target date fund invests in other mutual funds, and fees may be charged by both the target date fund and the other funds. Keep in mind that a fund with high costs must perform better than a low-cost fund to generate the same returns for you. Even small differences in fees can translate into large differences in returns over time.
You should also consider how a target date fund fits in with your other investments. If you have other stock, bond, or mutual fund investments, you should carefully examine your overall asset allocation.
In summary, before investing in a target date fund:
- Consider your investment style. Do you want to play an active role in managing your investments, or do you prefer the more hands-off approach of a target date fund? Keep in mind, however, that even with a target date fund, it is important to monitor the fund’s investments over time.
- Look at the fund’s prospectus to see where the fund will invest your money. Do you understand the strategy and risks of the fund, or of any underlying mutual funds held as investments?
- Understand how the investments will change over time. Are you comfortable with the fund’s investment mix over time? In particular, make sure you understand when the fund will reach its most conservative investment mix and whether that will occur at or after the target date. Does your level of risk tolerance match how aggressive or conservative it is?
- Take into account when you will access the money in the fund. How does the fund’s investment mix at the target date and thereafter fit with your plans for the future, whether they are to withdraw your money at retirement, or to continue to invest?
- Examine the fund’s fees. Do you understand the costs for both the target date fund and for any mutual funds in which the target date fund invests?
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