Your Target Date Fund May Take You Off CourseSubmitted by Castlebar Asset Management on May 15th, 2014
If you participate in a 401k or other work place plan there is a good chance you own a target date fund. So what are target date funds? They are mutual funds that invest based on a retirement year. If you are 41 years old and want to retire at 65 you would select a target date fund for 2035. As the funds move closer to its targeted retirement date, it starts to shift to a more conservative investment mix. Target date funds are a good option to save for retirement but not a complete solution.
Target date funds have grown significantly since 2006 with the primary driver being the 401k market. These funds are often the default option in 401k plans. Target date funds have grown five fold since 2006 to $595.5 billion. Casey, Quirk & Associates estimates that they will be half of the assets in defined contribution plans (401k, 403b and 457 plans) by 2020.
Here are some of the pros and cons of target date funds.
Easy & Convenient
Target date funds are touted as a “set it and forget” solution to your retirement needs. This is not necessarily the reality. These funds are easy and confident because you do not have to actively rebalance or change the investment allocation. The fund’s portfolio manager will take care of this for you.
As retirement draws closer most investors are looking to reduce their risk. These funds will monitor the asset allocation and reduce risk as the funds target date draws closers. Target date funds will rebalance throughout the year as the markets change to avoid allowing investment allocations to drift.
Target date funds do a great job of providing you diversification. They invest in a broad mix of funds both in domestic and international markets as well as in equities, bonds and alternative assets. This can be hard to replicate on your own in a 401k plan because of limited fund options but can be done outside of your work place retirement plan.
Not created specifically for you.
A common misconception is target date funds are created for your retirement needs. Target date funds are created for the needs of the average person retiring in the target year of the fund. If you are in a strong position for retirement or behind on your retirement saving the target date fund may not be the correct investment allocation to achieve your retirement goals.
Target date funds do not invest in individual securities but rather in other mutual funds. This is also known as a fund of funds. Reviewing the fees of your target date fund is important. The average annual expense ratio for target-date funds is 1.09%, according to Morningstar. Actively managed funds have an average expense ratio of 1.28% . If your target date fund charges more than 1% it may be good to seek an alternative solution.
Some funds have shortcomings in retirement.
Target date funds can be effective getting you to your retirement day but may prove to be sub-optimal in retirement. Your fund may not provide enough income to meet your living expenses in retirement. Also there is a distinction on the asset allocation strategy or glide path of different target date fund. This difference is how the are managed “to” or “through” the target date. Funds that operate in the “to” camp become the most conservative on the target date while “through” funds continue to scale down their risk through retirement. “Through” funds will have a more aggressive allocation at the target date than “to” funds.
Target date funds are a good solution but far from perfect. It is always important to review your retirement goals with a financial planner or investment advisor to ensure your investments match up with your goals.
Disclaimer: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.