How best to save and invest for your retirement should be carefully considered. An increasingly popular investment option is target-date funds, also known as life-cycle funds. They are offered by nearly 90% of employer-sponsored contribution plans, such as 401(k) plans. These funds are designed to manage investment risk. The investor chooses a fund with a target year closest to the expected retirement year.
For example, someone who plans to retire in 2050 would choose a 2050 fund. As the individual approaches the retirement target date, the fund will reduce risk by changing the investments in the fund. The funds will move from higher risk stocks to lower risk bonds. However, all people investing in these funds should know that even if the target date has been reached, funds with a target date are not without their own risks.
Target date funds are structured like a mutual fund. The specific investments in an investment fund are determined by the objectives stated in the prospectus. Most of these target date funds will be invested in mutual funds other than individual securities. However, what exactly are the pros and cons of these funds? There are pros and cons of target date funds that every investor should consider before making an informed decision.
Want to get a good 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 make one investment. While some people enjoy doing their own research and sorting out individual funds, many investors just find they don’t have the time or interest in them. A target date fund is not one fund but a bundle of investments. The simplicity of this makes it attractive to many investors. The simplest process available today is simply choosing the date of retirement and matching it with the fund. While some may argue that this may not be the best portfolio currently available, it is a reasonable asset allocation that will likely enable people to meet their retirement goals.
2. Diversified Funds
One of the most important principles when it comes to investing is the principle of diversification. This basic principle means that if one investment doesn’t perform well, other investments can make up for that lagging return. Predicting the future is simply impossible. Therefore, a diversified portfolio offers a wide range of future scenarios. A target date fund naturally offers investors a diversified investment portfolio. Not only does it diversify between stocks and bonds, but it’s also diversified across those asset classes. Individual securities in the fund can run into the thousands.
3. Reduces Investor Mistakes
Most investors will not invest much in researching their retirement fund. They should have a long term approach and avoid thinking short term as investments will make money and lose money in the short term. The biggest risk for many pension portfolios is the investor himself. Since a diversified portfolio reduces the volatility of the overall investment, it is easier for investors to stick to their plan and not pull out their money, even in a downturn in the market. The fund manages all aspects of the investment except for the money actually put into the fund. The target fund helps give investors peace of mind and helps avoid mistakes in the process.
Disadvantages of Target Date Funds
Of course, there can also be disadvantages to these funds. Consider these cons to get an idea of what would make this a bad choice.
1. Loss of Control
Just as this is a major benefit, it is also a primary drawback. Sometimes it can be great not to have control, but that also means that investors with investment knowledge cannot select their investments. They cannot select an asset allocation or glide path. The professional manager is responsible for this. However, for many investors, they can research the fund more closely and select the fund they want based on its asset allocation. This means that while it may be more work for those who want control, it is possible. However, for the non-savvy investor, this can be a disadvantage and incur costs in the long run.
Are you hearing about the term glide slope for the first time? Do you want to learn more about it? Read here.
2. Risk tolerance mismatch
The professional manager of the target date fund decides how much risk to take before retiring. This may mean that the fund is ultimately 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 pretty aggressive investment and can be more aggressive than what other investors would like to experience. Since investors cannot choose their own level of risk, they may find that the manager is not aligned with their own objectives. Or the most likely scenario is that the investor doesn’t even release the misalignment. Ignorance is more likely because most people don’t have time to sit down in the evenings 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 like Vanguard use a slightly more expensive investor fund rather than the cheaper Admiral share classes. This results in each investor paying about five or six basis points more than if you had designed the same fund using Admiral funds.
In addition, target date funds have a higher expense ratio. Some target date funds easily show that there is an additional expense. They stack an additional fund expense ratio on top of the underlying fund. Not all investment companies do this with their money. This is unfortunate for investors looking to maximize their wealth, but it is the price you pay for the convenience. The convenience of selecting just one fund that matches your retirement year.
While the cost of a targeted date fund may not seem like much in the short term, it can cost you retirement savings in the long run.
Make the investment
For many novice investors who don’t understand investments, the benefits of a targeted date fund outweigh the consequences. While this is a viable option, every investor should have an idea of what to expect before making a final decision. For investors who are either experienced and familiar with investing, or who want a more personalized approach that may help you better manage risk and potentially reduce costs, you’ll want to look for other options.
Investors unsure of this choice may also choose to put some of their retirement benefits into a target date fund and invest the remainder in other investments that meet their standards. Or better yet, take the step to work with an expert in the field who can 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. Schedule a time to talk to us and find out why people love working with BlackBird Finance.
Nathan Mueller, MBA
Founder and Principal Financial Coach for BlackBird Finance
Nathan guides people in overcoming money challenges, growing their wealth and understanding the intricacies of their personal financial circumstances. He is the founder and principal financial coach of BlackBird Finance. Website | Asset manager profile
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This post Should You Use a Target Date Fund?
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