A popular option for retirement investing.
Target-date funds are popular within employer-sponsored retirement plans. But, just because they are popular does not mean they are the right option for you personally. They are not all bad, particularly if you are just starting out or you prefer to put your retirement savings on autopilot. For people closing in on retirement, a more nuanced approach based on your individual goals may be needed. As with any financial decision, it is important to go in eyes open.
They are convenient.
Target-date funds can be useful in certain circumstances. They are often the default investment option if a retirement plan participant fails to choose their own funds. Some investors are paralyzed by all of the investment options, and they want an easy, all-in-one solution. However, if you have an interest in optimizing your finances and learning how to be a smarter investor (and most likely you do, considering you are reading this!), it is important to consider some of the pros and cons of these one-size-fits-all funds.
Individual needs vary.
Most target-date funds are named something like “Fund Company Retirement 2025”. The date in the name corresponds with the year you wish to retire. However, two people retiring at age 65 may have completely different lifestyles and income needs. Target-date funds cannot account for other important parts of your retirement picture, such as money you may have saved in a taxable account, or how Social Security will play into your retirement income. The funds also naturally have no consideration of the rest of your financial situation like real estate, business interests, debt and cash flow.
Risk propensity is important.
Two individuals who plan to retire in the same year may have very difference levels of risk tolerance. Target-date funds are one size fits all. A retiring 65-year-old with a working spouse who does not need to withdraw from the retirement account right away should have a different allocation than a single retiree who needs a sustainable withdrawal plan. A target-date fund cannot know whether the fund will be retained throughout retirement and used to support income needs, or if the funds will be withdrawn and spent at or near retirement. The allocation of a portfolio should be adjusted for an investor who is actively withdrawing from the portfolio versus an investor who has no withdrawal plans.
Concentration can be an issue.
These funds are designed to be a “one-stop shop” for your retirement account. Even though the funds are diversified, many investors are not comfortable simply parking their entire account into one single investment for many years. Target-date funds are meant to be the single investment in your account — so if you add others (thinking it will improve the diversification), it may only throw the risk-return profile of your portfolio out of whack. This will impact the suitability of the target-date fund as a part of your portfolio.
Allocations can be inconsistent.
The appeal of target-date funds is a manager adjusts the allocation to become more conservative as the investor approaches retirement age. But every manager has a different approach — so even funds with the exact same target date could have drastically different allocations and exposure to risk. Although each fund has a stated post-retirement mix, the path leading up to this date is not clearly defined. Funds have proven to be very inconsistent in how they manage the transition. A check of five target-date 2020 funds allocated equites from as low as 40 percent to as high as 54 percent, and the allocation toward bonds ranged from to 37 to 52 percent.
Watch out for fees.
The average target-date fund had a 0.66 percent expense ratio in 2017, according to a report by Morningstar. Some are well above this and others are well below this level. No matter what your investment approach is, keeping costs low means you keep more in your pocket to grow and compound for the long term.
Tax efficiency is not universal.
This is not a consideration at all in standard target-date funds. This means they are likely not suitable for holding within taxable accounts. Frequent trading within the fund or distributions from the fund can cause a tax liability. Naturally this is not an issue for an employer-sponsored retirement plan which is tax-deferred, but is just another consideration if you were thinking about using one of these funds in a taxable account.
What to know about target-date funds.
Here are seven things every investor should know about target-date retirement funds:
— They can be convenient.
— Individual needs vary.
— Risk propensity is important.
— Concentration can be an issue.
— Allocations can be inconsistent.
— Watch out for fees.
— Tax efficiency is not universal.
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