With over 7,000 different mutual fund options available to the average investor, selecting the correct choice can be tricky. Target-date funds are designed to help manage investment risk in a single diversified mutual fund. These funds are designed to work around your designated retirement year or “target” date.
In this article, we’ll discuss how you can compare different types of funds and the investment parameters you should consider before making a decision to invest in a target-date fund.
Make Sure That Target-date funds Meet Your Investment Needs
The first thing any investor should do is to determine their investment goals and risk tolerance. If you are not comfortable with fluctuations in the stock market, a target-date fund may not be the right fund for you. The farther out in the future the target date year is, the more risk the fund has.
For example, if you are looking to retire in 20 years, you should select the 2045 Target-Date Fund. As you move toward your retirement or any other target date of your choice, the fund gradually reduces risk by rebalancing. However, that doesn’t necessarily mean that the target date will meet all of your goals, even when the target date has been reached. Read how target-date funds work to become familiarized with this class of mutual funds.
Target dates work by gradually becoming more conservative over time, and shifting from stocks to bonds and/or cash. For example, the Vanguard Target Retirement 2060 is invested in nearly 88% stocks with the remainder in bonds and cash. Conversely, the Vanguard Target Retirement 2020 fund has 55% invested in stocks with the rest in bonds and cash. Due to its higher concentration in stocks, the 2060 fund will be more volatile than the 2020 fund.
So, what can happen is that despite having the opportunity to invest in a target-date fund (in this case an equity-heavy 2060 fund), you may be better off not investing in it because you might not have the required risk appetite.
Factor in Changing Life Events into Your Target-Date Fund Investment Decision
One of the reasons that target-date funds are so popular is their simplicity for the common investor. Target-date funds are designed to be a “one-size-fits-all” approach for investors who don’t have the knowledge or capability to choose their own investments.
In fact, many employer retirement plans automatically enroll participants into target-date funds based on their current age. However, this can be unsuitable for you if you don’t do further analysis between the different target-date funds and the other available options like low-cost index funds.
Over the course of your lifetime as an investor, your goals and risk tolerance can change several times. There may be years where you can go through the ups and downs of the stock market and be more aggressive with your investments. There may also be times where that risk must be minimized due to loss of income or having other goals that now take priority over retirement.
Either way, a target-date fund does not factor in these changes to your life and this is where you would need to handle your own asset allocation to mirror your new goals and risk tolerance.
Compare the Investment Expenses
Not all target-date funds are created equal – especially when it comes to expenses. The Vanguard Instl Trgt Retire 2055 is one of the lowest priced target dates available on the market, with an expense ratio of 0.10%. The Wells Fargo Dynamic Target 2055 A, with the same target date, has a much higher expense ratio of 1.08%. As of December 12, 2016, the Vanguard fund had a 1-year return of 10.41%, while the Wells Fargo fund had only a 6.54% return.
If your retirement plan offers only high-cost target-date funds, it might be better to select other investment choices, like index funds or exchange traded funds (ETFs), that have lower expense ratios. However, target-date funds are actively managed and may offer more flexibility to help you reach investment goals, despite their higher expenses.
For more information on mutual fund expenses, read this guide.
Key Considerations for Investors
Here are some parameters you should keep in mind:
- Do not invest and forget: A common misconception is to select a fund and not monitor its performance over time. Funds go through changes all the time based on the investment philosophy, management team and expenses. Forgetting about a target date-funds, even though it’s considered self-managed, could be very damaging in the long run if it does not continue to match your risk appetite during the tenure of the investment.
- Make sure to compare apples to apples: Another important factor is to consider the management company of the mutual fund and its underlying portfolio managers. There are several different investment companies that offer target-date funds, but not all excel equally in that strategy. For instance, the Invesco Balanced-Risk Retire 2050 Y is up 15.63% year-to-date (YTD) and is at the top of the 2050 target date category. Meanwhile, Franklin LifeSmart™ 2050 Retire Trgt Adv is closer to the bottom of the list and is only up 4.00% YTD. Even though both of these are 2050 dated funds, the Invesco fund is outperforming due to better asset allocation strategies by the portfolio managers. You should also note that this comparison may not be a fair one despite having the same target date of 2050. This is another complicating aspect of target-date funds, wherein each fund could have a different investment philosophy leading to different asset allocation mix.
- Be clear on your perception of the future performance of different asset classes: The movement of glide path, which is the how the fund changes its risk tolerance level over time, can also lead to different target-date fund returns. Some funds might do it more aggressively and move from stocks to bonds more quickly. By the time you make a decision, you need to be sure that your risk tolerance is aligned with the fund’s glide path.
- Preempt how to proceed when the target date is reached: Once a target-date fund hits its projected target date, you need to investigate how the fund will be managed from that point going forward. Most funds will be too conservative in nature and may not meet the required needs to keep you in retirement over the long term.
The Bottom Line
Before you invest, it’s important to understand the investment characteristics of a target-date fund and your risk tolerance. It might turn out that it’s not necessarily the right investment to fit your needs. You should carefully evaluate a target-date fund’s expenses, performance, management and investment philosophy to see if they meet your specific investment goals.
On the contrary, target-date funds can be an excellent choice for investors who want the simplicity of a self-managed, diversified fund but need to be careful and monitor it over time. Be sure to follow our Target-Date Funds section to make the best investment decisions.