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A Guide to Target Date Funds, Part II: Usage

In Part I of A Guide to Target Date Funds, we gave a brief description and some history surrounding their astounding asset growth.  In Part II, we reconvene to describe their pros and cons and when you might consider using them.

Part I also mentioned that target date funds are commonly used as default investment options in 401(k) plans.  While this has helped lead the funds to massive asset growth in the last ten years, they are also increasing in popularity independently.  Rather than take the time to consistently rebalance portfolios as they age, target date fund investors can invest in one and only one fund for the entirety of their careers.  This is one-stop shopping at its best. 

In addition to ease of use, many academic studies point to the fact that investors tend to manage their portfolios in a self-destructive manner.  Rather than stick to a pre-determined glide path and investment methodology, many people deviate from or abandon their rebalancing efforts altogether.  Rarely does this work out in their favor.  Other investors will show behavioral “biases” that hamper investment returns.  Someone whose portfolio was down 40% in 2008 may be scarred by the experience, and opt to put their entire portfolio in bonds.  While this may ease their pain and reduce risk, said investor would have missed out on the tremendous bull market in stocks over the last five years.  This could very well leave them below their target retirement savings level.  Target date funds take the emotion out of the equation, and allow investors to focus on making contributions to their accounts rather than making emotional rebalancing and investment decisions once they're funded.

Target date funds are not without their issues though.  While they are the best option for someone looking to “set it and forget it”, a target date fund’s asset allocation is as plain vanilla as it gets.  They allow for zero customization and totally neglect an investor’s subjective tolerance for risk.  For instance, even though a 60 year old may want to retire in five years, he may be comfortable taking on significantly more risk than a target date fund would prescribe.  Customization is simply not available.

Fees are another issue.  Target date funds are essentially “managers of managers,” in that they don’t pick individual stocks or bonds to build their portfolios.  A target date fund will compose the glide path and corresponding asset allocation, then invest in ETFs or mutual funds to build the portfolio.  Low cost index funds are predominantly used, and the structure adds an extra layer of fees.  Investors may pay 0.75% per year to invest in a target date fund, and then another 0.25% per year for the underlying funds the target date manager is selecting.

Some funds do embed the fees from the underlying mutual funds into their fund’s aggregate expense ratio.  But the fact some do and others don’t raises another important point.  There is a wide variety of target date funds, and their methodologies can differ greatly.  In addition to expense ratios, some target date funds will reach their most conservative points at the target date.  Others will reach their most conservative points after the target date.  This "to vs. through" debate is an important consideration for potential investors.  A ”to” fund will be more conservative and have less risk of loss in retirement, but also comes with the risk that retirees may outlive their assets.  “Through” funds continue chasing growth into retirement, but are inherently more risky.

When selecting a target date fund, it’s important to take these points into consideration.  And while your employer might offer target date funds in their 401(k) plan, remember that they’re not your only option.  IRAs and Roth IRAs have similar tax benefits as the 401(k), and a wider variety of funds to choose from.  While it’s important to maximize employer matches when making 401(k) contributions, remember to analyze your options in the plan and make an informed decision.

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