Understanding Target-Date Retirement Funds

By Ronald Kimmons. May 7th 2016

People saving for retirement have a number of options when it comes to investment instruments. One option that has become rather popular is the target-date fund, which is a type of mutual fund. Like other mutual funds, target-date funds consist of a collection of investments all rolled together. By pooling the money of many investors and many investments in this way, mutual funds bring down the potential risk for each individual investor. The thing that sets target-date funds apart from other mutual funds – and makes them particularly popular among those saving for retirement – is the fact that the investments they make for particular accounts differ depending on how close those accounts are to a target date each investor has set. However, you should not invest in a target-date fund without a full understanding of how the investment works and what the pros and cons associated with it are.

Investment Structure

One of the first basic rules for investment is that risk and reward are directly related. Those who chase after big money must take big risks, and those who do not want to risk anything must settle for slim rewards. For this reason, people early in their careers are often more willing to accept a higher level of risk for higher possible rewards, while people late in their careers tend to want a lower level of risk to protect what they have spent so many years building.

Typically, mutual funds appeal to people later in their careers because they are usually low-risk investments, while young investors prefer to strike out on their own, selecting specific investment instruments for themselves. Target date funds attempt to appeal to both groups by making riskier investments for people farther away from their target dates and making safer investments for people closer to their target dates. The point at which fund managers begin to make this transition – and the speed at which they do so – varies from one firm to another. (To learn more about mutual funds, see Helpful Tips On Investing In Good Mutual Funds.)

Investment Composition

The riskier investments that target-date funds make tend to consist of corporate stocks. Their more conservative investments tend to consist of bonds or money market instruments. Again, the ratio of risky versus conservative investments for someone at a particular point in the investment term differs from one firm to another. Some investors may find that their entire portfolio consists of low-yield bonds and other conservative investments by the time they reach their target date, while others may find that they still have stocks in their portfolios for several years after retirement.

Advantages

The principal advantage of investing in a target-date fund to save for retirement is that it takes much of the work out of making investments. Instead of actively playing the market early on and then shifting assets to conservative investments like mutual funds at a later period, investors can just put their money into target-date retirement funds and let the fund managers go to work. Thus, the intent of the target-date investment model is to combine a single investment solution that appeals to all investors – especially those preparing for retirement, whether their retirement date is near or far.

Criticisms

While target date funds appear attractive in theory, they do not always perform as well as one might hope or expect. In fact, in the economic downturn that began in 2008, many people who had placed their savings in target date funds lost a considerable amount of their wealth. Various reasons for this exist. First, target-date funds have not been around for very long. For this reason, many financial firms have not adequately adapted to manage investments in this way. For instance, a firm with a stellar management team for one asset class might have a sub-par management team for another asset class – but both of these teams will probably be involved in managing target date fund investments. Another criticism of target-date funds is that, while they can be aggressive early on, they may not be aggressive enough for investors trying to reach certain goals. Also, the “hands-off” nature of target-date funds tends to attract investors who do not like the idea of researching their investments – which may mean that those investors do not research the target-date fund before investing in it. This attitude can result in investors unwittingly putting their money into sub-par funds.

Alternatives

Those who decide that the disadvantages of target-date funds are too great may opt for some other investment instrument. A common choice is to invest in hedge funds early on and shift to mutual funds later. Hedge funds are aggressive investment organizations that actively manage a collection of investments focusing on specific markets or industries. They are riskier than target-date funds and other mutual funds, but they often bring considerably higher returns. Upon reaching or approaching the date of retirement, instead of putting their money toward target-date funds that may or may not be as conservative as they would like, investors may then put their money into normal mutual funds to ensure safe growth.

Another alternative to investing in a target-date fund is simply managing one’s own investments. By investing in a mix of stocks and bonds in a manner similar to what target-date funds do, investors can often enjoy returns that outperform what they otherwise would have gotten in a target-date fund.

The bottom line is that target-date funds can be good option for people who want to take a “hands off” approach to their retirement investing. However, there are downsides to investing in these funds. Keep this information in mind when you doing your retirement planning.

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