Congratulations, you are eligible to participate in your employer’s retirement plan! Your HR department sends you the overwhelming employee benefit packet that hardly any employee reads, but you are different – you are dedicated to understanding and getting what’s rightfully yours! If your employer provides a defined contribution plan like a 401(k) or 403(b), you get to select a percentage of your gross pay to withhold and invest each pay period. You hopefully elect to contribute at least enough to get the full employer match (if available), and now it’s time to choose how to invest these tax-deferred dollars. You may feel overwhelmed by the dozens of investment options or tempted to ask a colleague “hey, what did you choose?,” but thankfully there are resources available to help you understand this personal decision.
There are usually three types of investment options to mix and match within a retirement plan:
- Custom Fund Lineup: Like a toolbox, this list includes mutual funds across a variety of asset categories, including large-cap, mid-cap, small-cap, developed, and international equity, REITs, specific sectors, and corporate/government bond funds. You can choose one or more funds to build your custom portfolio, but be careful as this can lead to high asset correlation (all eggs in one basket) or even ‘naïve diversification‘ – believing that a selection of multiple funds equates to greater diversification and lower market risk.
- Target Risk Allocation Funds: These are designed to align with your personal risk tolerance, letting you choose between conservative, moderate, and aggressive options. The allocation between stocks and bonds does not shift over time, but instead stays within a range – like 50%-70% equity for a moderate growth example.
- Target Date Retirement Funds: As the subject of this article, these funds are managed to slowly shift from an aggressive to conservative investment allocation over time, aligned with your risk capacity. Below is an explanation of their unique characteristics, and I hope it provides clarity to your retirement investment decisions.
Target date funds are the ‘chauffeured’ approach to investing. Like a chauffeur who drives you to your intended destination using his or her chosen route, this fund is designed to ‘arrive’ at your desired retirement age (traditionally age 65). Unlike risk tolerance, risk capacity is determined by your investment time horizon, meaning ‘how long until you’ll need the money,” and the allocation between stocks and bonds is based on historical investment returns. This ‘set it and forget it’ approach be can helpful for investors who do not have the time, temperament, or talent to actively manage his or her retirement account throughout the years.
What’s in a target date fund?
A target date fund is like a basket of mutual funds, invested in thousands of diversified stocks and bonds across U.S. and international sectors. As previously mentioned, you could choose multiple funds from your custom lineup, but target date funds are intended to make your selection simple – choose a single target retirement year and focus your effort on other interests. The target retirement year is identified in the name of the fund; a 2060 fund could be appropriate for someone with a 40-year investment time horizon. The underlying funds are professionally managed by the fund company and rebalanced over time, shifting to fewer stocks and more bonds the closer you get to retirement. Here is a visual representation of how target date funds are allocated to more equity (stock) in the early accumulation years, then shift to more fixed income (bonds and cash) as retirement nears. I analyzed four fund companies for this example, but there are dozens more. These allocations are subject to change, and the data is as of August 31, 2020.
As shown above, the equity allocation of these funds stays above 80% until about 20 years before retirement, then de-risks to a conservatively balanced 40% to 50% equity allocation over the next two decades. You may have noticed that the equity positions level out at retirement age instead of falling to 0%; this indicates that maintaining equity growth in a retirement portfolio is essential to make the savings last up to 30 years or beyond. “Own your age in bonds” is a common investment rule of thumb that is not appropriate for most investors.
What are the disadvantages of target date funds?
- The fund managers do not understand the fund’s role in your personal financial landscape nor consider your other potential sources of retirement income. It is up to you to determine how this fund compliments your other retirement assets.
- The funds are professionally managed, so the internal expense ratios (cost of the funds) are usually higher than if you were to invest in passive index funds. This fee is like a tip to the chauffeur who drives you around. The extra cost may be worth the value if this fund keeps you from frequently changing your investment elections based on short-term volatility. Your deferred retirement accounts are designed to provide future income in retirement, so keep your time horizon in mind. Time is on your side, especially if you have decades to go!
- Many employer retirement plans select target date funds as the default investment election for new participants, with the fund year corresponding nearest to the participant’s 65th birthday. Age 65 may not be your desired retirement age, and you should review your elections as soon as you gain access to the account. Also review your 401(k) statements and pay stubs frequently to ensure your contribution amounts and elections are accurate.
- The risk capacity and corresponding asset allocation of your target date fund may not align with your risk tolerance; you may want a more aggressive or conservative allocation. This can be adjusted by picking a later/earlier fund date or manually customizing your investment choices. For example, you could select a target date fund for your core position then add another asset category to the mix (core and explore); create a recipe that’s right for you and do not hesitate to ask for help along the way!