Target Date Funds Revisited - Part 1
By Gary Silverman, CFP®
About 17 years ago, I wrote an article about Target-Date funds. It was an introduction to a class of funds that was just starting to show up on investors’ radars. Then 2008 happened (the Financial Crisis, in case you forgot about it) and it showed that many people who put money into these funds didn’t have a clue about what they had invested in. It got so bad that the Securities and Exchange Commission (SEC) launched an investigation.
Because of this, the SEC proposed some rules back in 2010. These mainly dealt with the information mutual funds must provide so that you will know exactly what you are getting yourself into. Frankly, most of the Target-Date funds already provided way more than what the SEC proposed, but I guess when in doubt, add more regulations.
Those rules never went into effect (politics), but they were followed up by yet another study by the SEC (they’re here to help). What did they find out? People were still confused about Target-Date funds. Well, you can’t say the government isn’t on its toes on this one. That was about 12 years ago when I revisited the topic.
Today I’ll re-revisit Target-Date funds. After all they are prevalent in 401(k) and other retirement plans and are used by millions of folks as the mainstay of their investing… even if they don’t understand them.
Let’s start with what a Target-Date fund is. The Target-Date fund is designed to bring simplicity to investing for retirement. You need only follow two steps.
Step One: Find the fund with the number closest to the year you plan to retire. For example, if you are retiring in 10 years you might look at a Target 2035 fund.
Step Two: Put all your retirement savings into that fund.
Simple? Yes... well, sort of. Step one is pretty simple. Step two causes indigestion for some people. Isn’t putting all your retirement savings into a single fund akin to putting all your eggs in one basket? Readers of this column know that I regularly preach to folks to diversify. Fortunately, though it may not seem like it, that single Target-Date fund is well diversified.
What about the diversification of other types of funds? Mutual funds (and ETFs) can invest in dozens, if not hundreds, of securities. Most invest in a single asset-type, like stocks, bonds, real estate, or cash-like securities. A special type, the Asset Allocation fund, further diversifies by mixing many of these different asset types together. Problem solved! Well… not all the problems.
While Asset Allocation funds are diversified across investments, they don’t change their risk profiles (stock for bond ratio) over time. These funds manage for thousands of investors who have a multitude of needs being satisfied by that single fund. Yet an individual often wants to reduce the risk in their portfolio as they get closer to and further along in retirement. In other words, people’s needs and their ability to stomach risk change over time.
That’s where the Target-Date fund is different. We’ll go into more detail next week.
