The Good and Not-So-Good
Target date funds go by lots of different names, including life-cycle, dynamic-risk and age-based funds. Usually in a mutual fund format (although often in collective trust funds too), target date mutual funds provide for one stop shopping and are designed to become more conservative as the “target date” approaches, which is usually retirement or when a child graduates from high school. In fact, target date funds are mostly used in those two scenarios – saving for retirement and saving for college.
The sponsor of the target date fund – a mutual fund company – manages the underlying asset allocation. In very simple terms, the mutual fund company’s portfolio manager will shift the allocation from higher risk/reward investments (equities) to lower risk/reward investments (fixed-income) the closer the “date” approaches.
So, if the “date” is say 20 years in the future, then the asset allocation is likely to be comprised of mostly equities, including asset classes further out on the risk/reward spectrum – like small-cap, international, and developing markets. If the “date” is in a few years, on the other hand, then the asset allocation is likely to include asset classes where the risk is much less, as is the reward. After all, preservation of capital at that point is of utmost importance.
Whether a target-date fund is the best choice for you depends on a lot of different factors, so let’s examine a few of the good and not-so-good characteristics of target date funds.
One-Stop Shopping. Target date funds are crazily easy to use and can be considered an “all-in-one retirement savings” or “all-in-one college savings” fund. Investors simply determine when they want to retire or when their child will start college and then they just focus on how much to save, rather than getting bogged down in making investment decisions.
Professionally Managed. Fund companies do quite a bit of back-testing and have professionals focusing on the asset allocations every single day. But more importantly, target-date funds automatically adjust their allocations as the “date” approaches.
Fees. Generally speaking, target date fund fees are comparable to fees from other mutual funds. The key term is “generally speaking.”
One-Stop-Shopping. While target date funds are crazily easy to use, the fact that they are considered an “all-in-one retirement” or an “all-in-one college savings” fund can be off-putting to investors who want more control over their asset allocation decisions.
Professionally Managed. Like any mutual fund, the target date funds are only as good as the mutual fund company and the portfolio manager running the fund. Some are very good and some are not very good. So, it is important to compare track records.
Fees. While target date fund fees are generally in line with fees from other mutual funds, this is not always the case. Most target-date funds invest in other mutual funds and there is a “layering” of fees that occur. For example, a hypothetical Target Date 2025 Fund might invest in 12 underlying mutual funds. So, as a shareholder of Target Date 2025 Fund, you pay the fees of the underlying funds. The key is to look at the net expense ratio of the Target Date 2025 Fund to make sure it is in line with your expectations.
In concept, target date funds can be terrific options for certain shareholders. But not everyone. And practically speaking, there are a lot of variables to consider; namely, the fact that not all target date funds are created equal.
If you’re considering a target date fund or want to learn more, give me a call so that we can walk through the pros and cons together.