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Investing Terms: Target Date Funds

by | Jan 24, 2019 | Investing

The last few weeks we’ve been in a series called “Investing Terms.” I’ve gone over the key reasons why you want to be investing your money for your future goals. And last week, I talked about “asset allocation” – what it is, and why it’s important.

This week I want to talk about certain types of mutual funds that help you manage asset allocation: Target Date Funds. If you’re part of a 401(k) plan at work you’ve probably seen these funds. They’re also in many 529 college savings plans.

These funds take some of the guesswork out of managing your asset allocation. But they’re not foolproof. I’ll show you some things to look out for as you look at your retirement & college savings investment options.

The “Problem” Target Date Funds are Designed to Solve

Last week, I said it was important to rebalance your portfolio on a regular basis. Most studies suggest annual rebalancing works well. Rebalancing keeps your investments in-line with your goals and risk tolerance.

Stock and bond markets move around a lot and over time, and after a while, your portfolio can become “unbalanced.” Let me give you a real-life example of how this plays out.

Example Asset Allocation: From Balanced to Unbalanced

Suppose you started investing $10,000 for retirement at the end of 2011. You determined that your time horizon was long (i.e. over 10+ years) and that you had an average risk tolerance. This pointed you towards an asset allocation of 80% stocks and 20% bonds.

I’ll use two popular funds to represent the stock and bond allocation: Vanguard’s Total Stock Market Index ETF (VTI) and Total Bond Market ETF (BND). 80% of your cash went into the stock fund (VTI) while 20% went into the bond fund (BND).

After 7 years, here is how your original asset allocation (80% stocks, 20% bonds) would have evolved:

The stock market has been strong for the last few years. Because of this, the original allocation of 80% stocks and 20% bonds would have evolved into an asset allocation of 89% stocks and 11% bonds by 2018. There are two problems with this:

  1. An asset allocation of 89% stock is taking a lot of risk. A lot more risk than most people can handle when the stock market goes down.
  2. You’d be 7 years closer to your goal. Remember from last week that you want to invest more conservatively as you near your goal.

Target Date Funds Attempt to Solve This Problem

Target Date funds are named that way because they “target” an expected retirement year. For example, if you’re 45 years old today and expect to retire at 65, you’d want to find a Target Fund that ‘targets’ the Year 2040. These funds tend to be named clearly….”XYZ Company Target Date Fund 2040.”

Time horizon is a key determinant for how aggressively you should invest. The shorter your time horizon, the less investment risk you should take. The longer the time horizon, the more investment risk you can take.

Target Date funds help you do this. As you near your goal, the fund puts more of your money in conservative investments. I’ve taken the chart below from T. Rowe Price, which is one of the leaders in Target Date funds.

On the left-hand side, you’ll see that the fund invests a lot into stocks. This makes sense. If you’re 10, 20, or 30+ years away from retirement, you have plenty of time to ride out the ups-and-downs of the stock market. As you get closer to retirement, the Target Date fund will start investing more of your money into bonds. Bonds tend to be safer and less volatile.

By investing in a Target Date fund for retirement, you don’t need to ‘rebalance’ your portfolio keep your target asset allocation intact. The fund does that for you.

Age-based Funds for College Savers

A very similar fund type exists for parents who save and invest for their child’s college education. These are often called “Age-based Funds.”

These funds will steadily reduce your exposure to stocks as your child nears Age 18. The idea is to protect your child’s savings from a bad year in the stock market right as they go to school.

To give you a sense for how this works, I’ve included a chart below from the Bright Start program in Illinois. Bright Start is the state’s 529 college savings plan.

When your child is young (pre-school) there is a heavy weight in stocks. Since they won’t go to college for 10+ years, you can absorb a bad year or two in the stock market. But as your child ages, these funds shift your investments towards bonds. That way, your child’s tuition savings are protected when they’re ready to head off to college.

Target Date and Age-based Funds Aren’t a Panacea

Everything I’ve said about these funds sounds good, right? These funds are about as close to “invest and forget” as you can get.

Yet there are two potential problems with these funds that you should be aware of.

First, they can charge fees that are higher than if you did the investing and rebalancing yourself each year.

When you buy a Target Date or Age-based Fund, you are buying a fund that invests in a handful of other mutual funds. This can mean you are paying fees on top of fees.

The best example I like to use is a McDonald’s meal deal. You can buy a Big Mac, large fries and large drink separately and pay about $7.00. But if you buy a Big Mac Meal Deal – which includes all three items – you’ll pay $6.00. You save money by packaging the items together.

Target Date and Age-based Funds are the opposite. Each mutual fund it invests in has its own fees. And it’s not uncommon for the Target Date fund to have its own fee on top of the mutual fund fees. In the Big Mac example, it would be like buying the Big Mac meal deal for $7.50, when you could just as easily order each item separately and only pay $7.00.

On top of this, the Target Date funds may invest in mutual funds that are too expensive. You don’t get to choose with mutual funds the Target Date fund uses. And the reality is that a lot of Target Date funds use more expensive mutual funds. These expenses can make a huge difference over the long-term.

Some Target Date funds have what they call “net expense ratios” of up to 0.75%. That might not seem like a big deal. But when you add up that cost over the course of 30 years, it becomes a big deal. You’d have almost 20% LESS in your retirement account after 30 years than you would have had if you didn’t pay that 0.75% annual fee.

It’s hard enough to save for retirement without wasting money on investment fees along the way.

The second issue with Target Date and Age-based funds is that they can be too aggressive or conservative for your risk tolerance.

Look back at those charts I referenced earlier for Target Date and Age-based funds. You can see that both start out with asset allocations of 90%+ in stocks. That’s a very aggressive asset allocation. Lots of people will struggle with the volatility that comes from such allocation.

On the other side of the coin, these funds can move to an asset allocation that’s too conservative as you near your goal. This is most applicable to Target Date funds which focus on retirement. You may spend 20 or 30 years in retirement. Because of that, you need to make sure you have an aggressive enough asset allocation to overcome the effect of inflation.

Conclusions on Target Date Funds and Age-based Funds

Target Date and Age-based funds can make investing easier for you. The take care of asset allocation decisions automatically. Generally speaking, they do a decent job managing your retirement and college savings investments.

But there are caveats to these funds, as we saw. They can be expensive, which can cost you real money over the course of many years. They can also be invested too aggressively (or not enough) for your situation.

The real issue I have with these funds is that they are “cookie-cutter.” Target Date funds assume you’re going to retire at Age 65. What happens if you want to retire at Age 50? Age 70? Or what happens if you’re a business owner and want to extract value from that as you get closer to retirement?

You’re not a cookie-cutter individual or family. That’s why I advocate working with a fee-only financial advisor. Fee-only advisors look at your entire financial picture. We tailor planning solutions to your family’s unique situation and desires.

I invite you to set up a free 1-1 consultation with me by hitting “Take the first step” below. I can dive into these investing topics and explain to you how a comprehensive financial plan – including investment management – can be of value to your family.

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