The Wall Street Journal ran a feature recently on the popular target date funds that are often found as an investment option inside of retirement plans. These funds are designed to manage risk based on the age that investor plans to retire, typically in five year increments (2020, 2025, etc.). The use of these funds has grown tremendously in the last decade because they are now the default investment if someone does not actively elect an investment choice. This was done so that plan participants wouldn’t sit idly in cash and miss out on return potential. That is a noble concept, but as the Journal points out, target date funds have some quirks that are worth understanding especially for those who are approaching retirement. If you have the option to own these funds in your 401(k), here are some things you should know (we use the Vanguard Target Date 2020 fund as an example)*:
- They are designed as a Funds of Funds. The Vanguard 2020 fund has five different funds inside of it, each representing part of the stock or bond market. To assess how the fund is invested, we need to look inside to see what the underlying holdings are. The balance between different kinds of a stocks and bonds can have an impact on performance.
- Be careful with comparing performance. Because they are made up of different assets, target date funds should not be compared to an all stock index like the S&P 500. Over the last decade, a 2020 fund would lag behind a U.S. stock index because it has bonds and international stocks (20% International in our example) that have not performed as well. 2020 funds should be compared to similar funds based on cost, holdings and long-term strategy.
- They are riskier than you might think. That could be a good thing, though. The year of retirement is not a finish line as we all hope to live long lives beyond then, and target date funds take that into account. Since there is a need to grow over what could be 20+ year of retirement, many funds will still have a sizeable portion in stocks well past the retirement year. In Vanguard 2020, there is over 50% in stocks for investors retiring next year. That might come as a surprise to someone who thought they were going to be very conservatively positioned by this stage.
- They are a good accumulation tool, but a blunt instrument for retirement planning. For people whose retirement horizon is far off, target date funds are a simple strategy that ensures diversification. Once the retirement situation becomes clear, the investments need to be more tailored than target funds allow. Two people retiring in the same year are going to have very different risk profiles and income needs. Odds are they need to invest differently based on the circumstances of their plan.
Target date funds have improved the investor experience in retirement plans but they run the risk of breeding complacency as retirement approaches. As with any investment, it is important to know both what you own and why you own it. A financial plan should tell us investor how much income and growth is needed in retirement and with that knowledge we can decide when a target date fund might no longer be a fit.