(Welcome as always to another installment of Investing 101, where we take a look at some of the many, many different types of investments in the financial world. This week’s subject is target date funds, a popular choice for retirement savings, especially in 401(k) plans. Understanding what they are and how they work is important if you are deciding if they are appropriate for your investment goals.)
Q: What are target date funds?
A: The term target date funds refer to several different products offered by financial companies. They all share several characteristics, though. First, they are ‘funds of funds’, consisting of several different mutual funds from the sponsoring family. Second, all the funds have a target date, when the investor is planning to stop depositing money into the fund and start withdrawing it. Finally, all the funds of this type gradually become more conservative in their investment holdings as the target date approaches (the fund mixture shifts from mostly stocks towards a higher portion of bonds and cash).
Two major uses for target date funds are to save for retirement and to save for college. Both of these goals are similar in that you have many years (if not decades) before you need the money. The target date funds can be more aggressive at the start of the investment period and have lots of time to shift the investment mix every few years and become more conservative.
Q: Why use a target date fund, then? Why can’t you simply shift your investments over the years by yourself?
A: The short answer is, you certainly can manage your investments on your own. Target date funds are just more convenient for many people. They allow you to invest in a single fund and have an investment mixture that is appropriate for your age and the length of time you have before you need the money. If you want to set up your investment plan and then not think about it again, a target date fund will serve you well. (Plus, when investing in 529 plans, your ability to shift your investments around is rather limited; using a target date fund will make it easier for your plan to stay on track to meet your college savings goal.)
Q: Sounds intriguing. What’s the catch?
A: One of the most significant problems is that different fund families follow different investment schedules. (Although, if Congress has its way, soon this may no longer be the case.) As a result, a Retirement 2010 fund from Vanguard might have 50% Stocks/50% Bonds, while the 2010 Fund from T. Rowe Price has a 60% Stocks/40% Bonds mix. If you don’t know what mixture your fund offers, and how it will change over time, you could find yourself holding investments that are inappropriate for your goals and risk tolerance when it comes time to withdraw your funds.
Along the same lines, you might not be able to find a target date fund whose investment progression matches how you want your portfolio to change over time. If you think that a 50/50 mix of stocks and bonds a year before retirement is too risky, neither of the above funds will meet your needs; the same holds true if you want more stock exposure as you begin retirement. And of course, the schedule for shifting the asset allocation might not meet your needs, either.
Q: What can I do to get around these problems?
A: Well, there are several possibilities. If you’ve researched the major fund families, and haven’t found an appropriate fund for when you plan to retire from any of them, you can consider purchasing a plan with a different retirement date. Funds with later dates will be more aggressive in their composition, while funds with earlier dates will become conservative more quickly. If shifting dates does not solve your fund composition problems, you could try buying another fund or two to compliment the target date fund. That way, you could boost your stock or bond holdings while continuing to keep the automatic investment shifting of the target date fund.
If neither of these options goes far enough in fixing the problems you have with the funds’ holdings, you could always forgo using a target date fund at all, and create your own personal mix from the available mutual funds at your preferred fund company. You’d be giving up the automation of the target date fund for the increased control and effort of a do-it-yourself approach; whether that’s a good trade depends a lot on you and your personality.
I hope you’ve enjoyed this discussion of target date funds, and now have a better appreciation for how they could be used in your portfolio.