Over the last few years, target retirement funds have become increasingly popular choices in retirement plans. In just one of these diversified funds, you can invest in both the US and international stock markets, along with safer bond-type investments. Target funds become more conservative as you near the target retirement year that’s built into the fund. So a fund that targets 2020 as a retirement year will be invested more in bonds than a 2040 fund.
Target retirement funds are now available in most retirement plans. Some local examples are the University of Colorado, which offers Vanguard funds as do local employers Google and Ball. Federal government employees can access TSP Lifecycle funds, while PERA-covered employees can invest in BlackRock Lifepath funds.
Target retirement funds have been a fantastic addition to the retirement plan mix, but you should recognize their pitfalls before investing.
How will it fare through a bear market? Target retirement funds have gained popularity during one of the longest positive stock markets in history. In particular, investors under 50 have seen excellent returns over the last nine years as their assigned investment mix is mostly in stocks. To say target funds are a good investment choice is like saying that your high-powered, rear-wheel drive sports car performs great on the streets of Colorado. If you’ve never driven your car through a snowstorm, you really don’t know how it’s going drive in all seasons. Confidence in these all-in-one funds may be fragile when winter comes during the next bear market and these funds go down in value significantly.
Does one size fit all? Implied in the design of these funds is that you should pick the target fund with your projected retirement date. But this formulaic approach doesn’t consider your particular financial situation. If you’re collecting a pension and won’t need to use your retirement plan to fund everyday living expenses, you may invest more in stocks than most retirees because it’s really for your grandchildren. Alternatively, you may want to invest a high percent in bonds because you’d like to use your extra cash for traveling and don’t need to take risks in the stock market to accomplish your goals.
It’s best used as the only holding. We often see target retirement plans as one of several investments in a person’s 401(k) plan. They might put some money in international stocks, some in US growth stocks, add a little world bonds, and then put the rest in the target fund. Target funds are not designed to be an ingredient in your financial independence recipe. They are the entire meal! To use target funds correctly, they should be the only investment choice you make in your retirement plan unless you’re a sophisticated financial wiz.
Ignores tax considerations. For investors with savings in multiple types of accounts such as pre-tax 401(k) plans and IRAs, tax-free Roth IRAs, and taxable investment accounts, we should consider the asset location of the investments you’re making. Some investments including those with high expected growth are best held in tax-free accounts, while others that generate ordinary income are better for tax-deferred IRAs and retirement plans. When you invest in a target fund, you can’t design your portfolio to take advantage of the tax characteristics of different types of accounts.
In truth, these downsides to target funds are quibbles when compared to the advantages most people enjoy when they’re made available in a retirement plan. It takes a lot of the decision-making and rebalancing chores out of your hands. It adjusts the recommended asset allocation to be more conservative as you grow older. Moreover, target funds generally have lower costs particularly the index type versions. For a simple clean investment choice, they are hard to beat.
David Gardner is a certified financial planner with a practice in Boulder County and can be reached with questions at firstname.lastname@example.org or twitter.com/Dave_CFP.