Target date mutual funds seek to make retirement planning as easy as ever. Simply pick a date and a contribution level to let the target date fund manager do the rest for you.
The goal for any fund company is to become a “one stop shop” for their clients. A target date fund gives much broader diversification than your average mutual fund.
How Target Date Funds Work
Target date funds are generally funds of funds, meaning the fund invests in other mutual funds and exchange-traded funds. The fund’s specific holdings are adjusted based on the amount of time to retirement. The portfolio is automatically rebalanced to keep within commonly-accepted diversification and asset allocation levels.
As the length of time before retirement goes up, so does the percentage of assets in more volatile asset classes like stocks. As the time to retirement goes down, fixed-income products like bonds make up more of the fund.
Lifecycle Fund Riskiness
In general, I think target date and lifecycle funds result in better outcomes for ordinary investors who have limited understanding of asset allocation. Most people know when they want to retire, and I would assume a majority understand that it will be in their late 50s at best, and on average, in their 60s.
But there is still a difference in opinion when it comes to asset allocation. For example, iShares S&P Target Date 2035 (TZO) holds 55% of its portfolio in US stock, 25% in international stock, and 15.65% in bonds. American Funds Target Date 2035 holds 53% of its assets in US stock, 30% in international stock, and roughly 9% in bonds.
See the differences in exposure? This is a hot topic in the world of retirement planning. There are literally hundreds of target date funds, and several for each different retirement date. The problem is that every manager seems to have a differing opinion about how you should allocate your retirement portfolio to retire by a specific date.
Making the Most of Asset Allocation Decisions
Target date funds are best for people who have a very long time to retirement. Those who are younger than 35 arguably derive more value from a target date fund than people who are nearing retirement. I don’t think a target date fund really creates all that much value for people closest to retirement. In fact, target date funds can be downright dangerous.
Here’s a 5-year chart of the American Century LIVESTRONG 2015 (ARFAX) fund:
As you can see, the fund seems to have been far too aggressive in its asset allocation. Notice how the fund lost more than one-third of its value from 2007 to 2009. In 2007, someone with a target retirement date of 2015 had only eight years to retirement. The fund was very, very aggressive for someone so close to retirement. While the fund did recover, I don’t think there are many financial planners who would have been so risky with their allocation only eight years from expected retirement.
Thankfully, greater wealth tends to correlate with age. And greater wealth makes it possible to pay for individual advice.
For 20-somethings and younger 30-somethings, a target date retirement fund picked with the idea to retire on the worker’s 65th birthday is a reasonable and safe wager. As time goes on, however, investors would be better to ditch the plain-vanilla plan in a target date fund to seek individual advice.
Depending on the particular fund, the fee to hire your own financial planner is much less expensive than the long-run cost of a target date funds. Some target date funds are downright cheap – iShares’ funds have an expense ratio of .3% across the board. American Century is far more expensive, with expense ratios of more than 1% per year on its loaded funds. (American Century sales loads are massive…5.25% for the first $50,000 in invested capital.)
In short: Target date funds are great for people who would spend a greater percentage of their assets to hire a financial planner for a once-a-year review of their asset allocation. Otherwise, investors with more assets who are closer to retirement would do much better with an individualized plan. There is significant “wiggle room” in your retirement plan in your younger years, but absolutely no room for error at retirement (see more in Retirement Articles).