When you look over the investment options in your retirement plan, you probably see a 2020 fund, a 2030 fund, a 2040 fund, and on up the line. Those are “target date funds.” They can be mutual funds, exchange traded funds, or pooled separate accounts. But what are they and what are they designed to do?*
A target date fund is an investment vehicle that invests in equites, bonds, and other funds. What’s different about a target date fund is its stated goal. It does not claim to simply maximize your investment return.
A target date fund’s goal is to gradually transition your retirement savings – from riskier investments when you are young to safer investments when you near retirement. A 2040 fund will be highly invested in stocks with very few of its assets devoted to safe investment vehicles like bonds. For example, this John Hancock mutual fund, the Retirement Living through 2040 Portfolio, has only 4.6% of its assets devoted to bonds and nearly 35.7% of its assets devoted to aggressive growth stocks.**
This level of risk would be irresponsible for someone on the verge of retirement. Over 95% of this portfolio is invested in stocks that could be highly volatile. However, the belief is that this level of risk is both acceptable and beneficial to a young investor who has time to play the risk versus reward game.
In contrast, a 2015 fund, such as this American Funds 2015 Target Date Retirement Fund, has 35% of its assets allocated into bonds and another 20% of its assets allocated into equity funds that are made up of low risk equities.**
Now, to the pros and cons.
These funds can be great for the investor who does not want to take an active role in choosing investment funds or making investment decisions. Those decisions are made for you in a target date fund. A target date fund even offers some internal diversification in that the fund itself is spread out over a wide range of investments.
Unfortunately, there are two substantial negatives that come with these funds.
The first is cost. Target date funds tend to be more expensive than other funds. There is a reason for this. You are paying for two things with a target date fund: the underlying cost of the management of your money and the cost of the administration of the target date process, including those decisions about when and how much money should be moved and to riskier or safer investments.
The second is that, even with the internal diversification, it is always a mistake to rely too heavily on one fund. Whenever you invest in any fund, the risks range from good faith underperformance to outright fraud. Any time you are overinvested in a fund, your retirement savings are at risk if something goes wrong.
There is a tendency for participants to allocate a large percentage of their retirement savings to a target date fund and simply forget about monitoring the investment. I urge participants to consider the diversification risks along with the positive aspects of a target date fund before making a decision.
* As always, this blog is not to be taken as legal advice. In addtion, please do not take this entry as financial advice. This is simply a description of an investment product so that you can be an informed participant in the retirement market.
** This is just a fund that I picked as an example. Please do not take this as an endorsement of this fund.