Should You Use a Target Date Fund?

How to best save and invest for retirement should be a careful consideration. One increasingly popular investment option is target date funds which may also be referred to as life-cycle funds. They are offered by almost 90% of employer-sponsored contribution plans such as 401(k) plans. These funds are designed to manage the risk of investment. The investor will pick a fund that has a target year which is closest to the anticipated retirement year.

For example, a person who plans to retire in 2050 would choose a 2050 fund. As the individual moves toward the retirement target date, the fund will reduce the risk by changing the investments in the fund. The funds will change from higher-risk stocks to lower-risk bonds. However, all people investing in these funds should know that target date funds are not without their own risks even when the target date has been reached.

Target date funds are structured as a mutual fund. The particular investments in a mutual fund are determined by its objectives which are disclosed in the prospectus. Most of these target date funds will be invested in other mutual funds than in individual securities. What exactly are the benefits and disadvantages of these funds though? There are pros and cons of target date funds which each investor should consider before making an informed decision.

Want to get a firm understanding of a mutual fund? Read this short article.

Benefits of Target Date Funds

1. Easy to Use

What makes this attractive to investors is that you only have to have a single investment. While some people may enjoy doing their own research and picking out individual funds, many investors simply find that they don’t have the time to do this or have interest in doing so. A target date fund is not a single fund but instead a bundle of investments. The simplicity of this is what makes it attractive to many investors. To simply pick the date of retirement and matching it to the fund is the simplest process available today. While some may argue that this may not be the best portfolio available today, it is a reasonable asset allocation that is likely to allow people to meet their retirement goals.

2. Diversified Funds

One of the biggest principles when it comes to investing is the principle of diversification. This basic principle means that if one investment doesn’t do well, other investments will may up for that lack of performance. Predicting the future is simply impossible which is why a diversified portfolio allows for a wide range of future scenarios. A target date fund provides investors with a diversified investment portfolio naturally. Not only does it diversify between stocks and bonds, but it is also diversified in each other those asset classes. Individual securities in the fund can be in the thousands.

3. Reduces Investor Error

Most investors are not going to be highly invested in researching their retirement fund. They need to have a long-term approach and avoid thinking short-term since investments are going to gain and lose money in the short term. The biggest risk to many retirement portfolios is the investor themselves. Since a diversified portfolio reduces volatility of the overall investment, it’s easier for investments to stick with their plan and not pull their money out, even in a market downturn. The fund controls all aspects of the investment except for the money that’s actually put into the fund. The target fund helps to give investors peace of mind and will help to avoid making mistakes in the process.

Disadvantages of Target Date Funds

Of course, there can also be downsides to these funds. To get an idea of what would make this a poor choice, consider these downsides.

1. Loss of Control

Just like this is a main advantage, it’s also a primary disadvantage. Sometimes it can be great to not be in control but that also means that investment savvy investors can’t select their investments. They can’t select asset allocation or glide path. The professional manager is in charge of that. For many investors though, they can research the fund closer and select the one that they want by the asset allocation. This means that while it may be more work for those that want control, it is possible. For the non-savvy investor though, this can be a disadvantage and end up costing them in the long run.

First time hearing about the term glide path? Want to learn more about it? Read here.

2. Risk Tolerance Mismatch

The professional manager on the target date fund makes the decision on how much risk to take on before retirement. This could mean that the fund ends up being less risky than desirable or vice versa. For example, most funds start with 90% stocks and stay at that level for years. That’s a fairly aggressive investment and may be more aggressive than what other investors would want to experience. Since the investors can’t choose their own risk level, they may find that the manager doesn’t align with their own goals. Or the more likely scenario is the investor doesn’t even release the misalignment. Ignorance is probably more likely to happen because most folks don’t have the time to sit down at night after work and analyze their target date fund.

3. More Expensive

What may be surprising to some investors is that a target date fund is more expensive than building your own investment portfolio. However, investors such as Vanguard use a slightly more pricey investor fund instead of the cheaper Admiral share classes. This ends up with each investor paying about five or six basis points higher than if you designed the same fund using Admiral funds.

Additionally, target date funds carry a higher expense ratio. Some target date funds easily show that an additional expense is present. They stack an additional fund expense ratio on top of the underlying fund. Not all investment companies do this with their funds. This is unfortunate for investors that want to maximize building wealth, but it is the price you pay for the convenience. The convenience of just selecting one fund appropriate to your retirement year.

While the cost of a targeted date fund may not seem like much in the short-term, it can end up costing retirement savings in the long run.

Making the Investment

For many beginner investors that don’t understand investments, the benefits of a targeted date fund outweigh the consequences. While this is a viable option, each investor should have an idea of what to expect before making a final decision. For investors that are either experienced and comfortable with investments or want a more personalized approach that potentially could help you better manage risk and may reduce cost as well you will want to seek out other options.

Investors who are unsure of this choice can also decide to put a portion of their retirement in a target date fund and invest the remaining portions in other investments that meet their standards. Or better yet take the step towards working with an expert in the field that can properly understand your personal situation and tailor a portfolio to you.

At BlackBird Finance we work with people of all income levels with the goal of accelerating your financial prosperity. Set up a time to speak with us and find out why people love working with BlackBird Finance. 

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