Maybe your 401(k) is invested in a target date fund, or you’re considering a target date fund for your IRA. You should know about the growing debate around an important question: How well do these funds work as retirement savings vehicles? Read on for the pros and cons of these popular funds.
Find out now: How should I save for retirement?
The target date fund (TDF) works like this: You choose a fund based on your desired retirement year and the fund re-balances itself based on how close you are to retirement, saving you the effort of tweaking your stock and bond allocation.
When you’re young and retirement is just a far-off daydream, your TDF will give you more exposure to risk and more potential for reward – translation: a higher percentage of your holdings will be in stocks and a lower percentage in bonds.
Later, when you’re approaching retirement, your portfolio allocation will be less risky (think bonds, CDs and money market accounts) on the theory that a more conservative approach is appropriate as you get closer to your non-working years.
A great idea at the time: the pros of a TDF
A TDF is an approach to retirement saving that’s designed to save you from yourself. What do we mean by that? Well, with target date funds there’s no way for you to tinker unwisely with your retirement allocation, buying stocks when they’re high, for example. And for the average overworked American, a retirement savings vehicle that requires minimal effort has maximal appeal. The funds allow you to take a hands-off approach that is a) easier and b) reduces your chances of wiping out your retirement savings if you decide to engage in DIY investing that doesn’t go as planned.
TDFs manage your risk, giving you more potential for reward in the early days of your career, and less risk when you’re older and closer to needing your retirement funds. In theory, TDFs make perfect sense. No one wants to be a year away from retirement and heavily invested in stocks if it means they could lose everything in a market downturn.
Has the TDF outlived its usefulness? The cons
If TDFs are easy and relatively low risk, what’s the beef with them? Well, with people living longer, critics of TDFs say that the funds leave the average retiree vulnerable to what’s called “longevity risk,” the risk that you’ll outlive your retirement savings. With many TDFs, by the time you hit retirement you’ll have only 30% of your money in stocks.
But what if you need more returns than this allocation can produce, either because you haven’t saved very much or because you’re going to live to a very old age? Or, what if the year you retire happens to be a great year for stocks, and you’re missing out on potential gains? These questions have led some in the industry to question the usefulness of the TDF. The funds were designed to re-balance relative to your age, not relative to how the market is performing, so they’re unlikely to optimize your returns.
Some TDFs can also carry hefty fees that cut into your retirement savings. Recent regulation has tried to make it easier for workers to identify the fees that come with different 401(k) options, but surveys show that many of us still don’t understand how our 401(k)s work. Worse still, many Americans believe that saving in a TDF means guaranteed retirement income. Nope. While TDFs are designed to minimize the risk that your retirement savings will disappear in a recession, they are not risk-free and they’re not defined benefit plans.
Find out now: How does my 401(k) work?
Another feature of the TDF is that it is designed to act as your only investment vehicle, meaning that it re-balances itself without regard to any other assets you may have. If you have other retirement savings in a combination of stocks and bonds, your TDF won’t take that into account. The result? You might be over- or under- exposed to risk and insufficiently diversified, so you’ll have to do some DIY re-balancing to make sure your taxable accounts complement your TDF.
In the future, workers may have the option of investing in a long-term life cycle fund that takes the good aspects of the TDF (you can “set it and forget it,” the fund manages your risk as you age) while addressing some of the current downsides. Such a fund might re-balance more frequently to increase the chances of realizing gains when the market is going up and limit losses when the market is going down. In the meantime, a low-fee TDF can still be a good option for someone who doesn’t want to fiddle with their own retirement investments.
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