Target Date Mutual Funds

Target date mutual funds have become a staple in employer sponsored retirement plans. There are positives and negatives to target date funds, but for most people, the positives outweigh the negatives.

You will recognize the target date funds in your retirement plan because the series will have a year in the name of the fund. The names might be something like Target Retirement 2030. The 2030 represents the approximate year of expected retirement. The funds generally come in a series with retirement dates every five years from the nearest current retirement fund out to 2060. Over time the dates shift out farther. These funds are designed to be one stop investment alternatives that you can hold for your entire career, and have a mix of equities, bonds and cash as well as hard asset investments, such as commodities and real estate, in some cases. As the retirement year approaches the proportion of the fund invested in equities declines and the proportion invested in bonds and cash increases, making the fund less risky (though definitely not risk free) over time.

General criticisms of the funds are that the investment fees can be high, and that fund managers stuff the funds with the underperforming funds in their stables. Target date funds are “funds of funds”, which mean they are a combination of other mutual funds. Investments in equities, bonds, and other investment categories are achieved through investments in mutual funds that are managed by the same mutual fund company. Each of these mutual funds has expenses, and the fund company may layer on an additional expense on top for managing the combination of funds within the target date fund. Whether the overall expense for the target date fund series is reasonable depends on the fund company, as with any mutual fund investment. And, in my years researching mutual funds, I definitely did run across target date funds where the underlying mutual funds included some dogs, but you can’t paint all target date funds with the same brush here either. Again, it all depends on the fund company.

Critics argue that retirement plan participants could do better by building their own investment portfolio. This allows participants to take advantage of the lowest cost and best performing investment options the plan has to offer and to tailor the investment strategy to their own specific situation. Quite frankly, this is likely true. In most plans, it is possible to put together at least a lower cost investment portfolio, and obviously if you build your own portfolio it will better reflect your point of view and situation.

However the fact is that most retirement plan participants do not have the skills, time or inclination to manage their own retirement account. Whether they are engineers or staff assistants, most participants do not understand the investment options in their plan, nor do they know how best to invest for decades in the future or diversify their investments. No one suggests plan participants should wire their cubicles for electricity to save money and personalize their energy usage, so why would we expect participants to manage their investments for retirement to save expenses and personalize their investment strategy? Both require a unique skill set, and unless you are an electrician or an investment professional, you probably can’t do either easily.

Target date funds were particularly sharply criticized following the Financial Crisis and labeled as too risky. Funds for near retirees, or in other words, the funds with the nearest retirement dates, lost value during the crisis with some down over 30%  at points during the six months the crisis was in full swing. Even the most conservative funds held substantial allocations to equities, which were down more than 25% just in September and October of 2008, the first two months of the crisis. To make matters worse, the lower risk corporate bond holdings in these funds were also down more than 7% in those two months. Equities continued to decline through February of 2009, though corporate bonds recovered somewhat.

Even for near retirees, the typical investment strategy for the target retirement fund is appropriate for the long time you need your money to last. The intention of your retirement plan is to provide a place where you can accumulate enough money to last you for 25 to 30 years, and that time horizon needs a big dose of equities to provide the growth that will help the money last. The downside (literally) is that, given the typical proportion in equities, these funds will lose value in about 2 out of every 10 years, and if your first year in retirement is one of these two, and your first withdrawal is a large proportion of your account, you may not recover. The problem however isn’t with the investment strategy. The problem is that not enough has been saved. In order to withstand the risk of any equity investment, whether as part of a target date fund or separately, you have to have enough set aside so that withdrawals during down years are relatively small.

Target date funds offer a single managed alternative that will give you an investment that will be reasonably appropriate for you given when you expect to retire. You don’t need to do anything with it, because the fund manager maintains the investment strategy, and as you approach your retirement date, the fund will become more conservative. If you are near retirement and you will be drawing down your balance quickly, target date funds are not the right choice for you, but for everyone else they are a sensible way to invest your retirement savings.

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