Saving for retirement isn’t simple, which is perhaps why Americans are so bad at it.
Target-date funds seek to take some of the complexity out of building a nest egg by automatically recalculating the investment mix, depending on the saver’s age. And while target-date funds have their enthusiasts, some personal finance experts believe workers may be short-changing themselves by going all in on target-date funds.
Before weighing the pros and cons, however, it’s best to start with a quick explainer of what target-date funds are.
As the name suggests, target-date funds are composed of investments with an asset mix of stocks, bonds and cash that shift as the expected retirement year nears (2030, 2045, etc.) — or in the case of a 529 plan, when a child expects to start college.
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For example, a fund with a target retirement date of 2045, geared toward those born around 1980 or so, would be comprised mainly of stocks, seeing as investors in their mid-30s are likely more focused on growing savings than preserving capital.
It’s important to that note that while your employer’s 401(k) plan may try to steer you into a plan with a target year that coincides with turning 65, there’s nothing stopping you from investing in a fund with an earlier or later target date.
Target-date funds provide savers a simple alternative to a complex decision, says Michael Guillemette, a University of Missouri professor with a doctorate in financial planning and co-author of a recent report on TDFs. These funds allow investors to put their savings goals on autopilot and provide the benefit of professional money management, diversification and automatic rebalancing.
“Such benefits are important to individuals who might make severe investment mistakes,” the report notes.
While TDFs can’t guarantee returns or eliminate the risk of losses, they do provide a level of investment expertise that average investors typically can’t afford. Still, Guillemette says, while these funds are satisfactory they aren’t optimal because they don’t take into account several factors, including an investor’s willingness to deal with uncertainty.
It’s that lack of flexibility that prompts some financial experts to suggest that savers can do better than putting all their savings in target-date funds.
Focusing a savings plan on a specific year leaves out an important consideration, says Andrew Gardener, president of Tanglewood Legacy Advisors in Houston. “Target-date investments make perfect sense when you know an end date, like college. You know that a 10-year-old will very likely need the funds in 8 to 12 years,” Gardener says.
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Retirement, however, is far less predictable, and a saver’s investment strategy should take into consideration that retirement may last not just years but decades. “What good is a portfolio with a risk (horizon) of 12 months for a portfolio that may need to last 12 years or many more,” Gardener says.
What’s more, though the funds are geared toward risk-averse investors, TDFs have been guilty of taking more risk, since ratings are based on past performance, says Robert Schmansky, a certified financial adviser with Clear Financial Advisors in Livonia, Michigan.
“A target-date fund doesn’t eliminate the need to know what you are invested in,” Schmansky says. “In fact, they call for more scrutiny than selecting a mix of funds yourself.”
He notes that some TDFs take savers to retirement, while others claim to take them through retirement. That results in some funds making large changes in allocation during the target year for retirement, regardless of the age of the investor.
“Further, the funds don’t take advantage of asset location, and often don’t take advantage of the best options available to you within your 401(k),” Schmansky says. For example, a well-rated, stable value fund will likely earn more than the money market allocation within a TDF.
So what’s an investor to do? Key is knowing your own aversion to risk — how much uncertainty you are willing to deal with in the pursuit of higher gains. Research is also key and doesn’t require as much effort as the fine print on every prospectus would suggest. What you’re looking for are which funds and asset classes the TDF invests in and how those change over time.
Further, fund information providers, such as Morningstar, can provide insight into past performance, where the fund ranks among peers and costs associated with the fund.
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Ultimately, you’ll become a more informed investor, and better able to determine which target-date fund is best for you — or whether TDFs are the best investment for your investment style.
After all, there’s no reason to settle for satisfactory returns when optimal results may simply be an investment away.
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Are Target-Date Funds for You? originally appeared on usnews.com
