If you have a 401k or have talked to a retirement planner, you probably have come across the idea of investing via a Target Date Fund (TDF). A TDF is a type of fund that is composed of other specific funds. As you progress towards the future target date, the TDF automatically adjusts its fund allocations (equities, bonds, cash).
A TDF’s target market is investors with retirement in mind that wish to have a more auto-pilot approach to obtaining their retirement goal (in terms of money). Investors concerned about the management of their risk exposure, in theory, do not have to worry since the fund will adjust the amount of risk it carries as it approaches the target date. The idea of investing with a TDF can be very compelling for the passive investor.
When I hear about nifty services like TDFs that take a lot of hassle out of investing the first thing that comes to my mind is, “What am I giving up to gain this service/advantage?”
Fees: The first thing that comes to mind when I hear about funds that are designed to be a shell holding a bundle of other funds are associated fees. I have come across such funds when discussing investments with people throughout the years and the fees can be sold in a rather dubious manner.
If the fund has a very low fee or no fee at all, make sure the company is not sneaking the fee in an indirect manner. Does the account have a service fee or some other expense? If the fund does specifically state it has a fee, probe further than find out ALL of the fees. You could have a situation where you have a TDF management expense plus the management expenses of all the mutual funds being held. If this is the case, I would strongly recommend you do not invest your money in such an instrument. Your investment return will be beaten down by two layers of fund fees.
Transparency: As I’ve mentioned before, TDFs are set up to hold a basket of other funds. Therefore, it is often more difficult to understand the specifics of how your money is being invested via a TDF. You will know allocations, but you are likely to have to dig further to find out about the funds being used and what those funds actually hold.
For example, if you enter into a TDF and on the start date you’ll have a 60% (equity) / 40% (bonds) split, what does the equity portion and bond portion actually consist of? It’s most likely to be found through number of other fund and their actual investments. What do they hold and more importantly, how have they performed against their index over the past X years? Ideally you want each fund that is supporting your TDF to outperform its index or at least match the index once management fees are subtracted.
The bottom line is that transparency within a TDF is going to be cloudier than if you were investing specifically in one fund. It’s the nature of TDFs.
Control: For most TDF investors control is something they are looking to transfer to another party. One of the main selling points of a TDF is having a team of professionals take control of the money you are looking to invest.
It should not be forgotten that the point of a TDF is to be a vehicle to take you to your retirement goal through transferring control of your investment money. Let me clarify. If you are also placing money in another fund that you are managing for retirement, you can easily poison the strategy you bought into with the TDF. For instance, if you want to control risk, but hold a separate account with 100% stocks, then the balance of your nest egg is dramatically different than what the TDF’s strategy is seeking to accomplish. Having extra cash and engaging in these activities is fine, but remember the TDF has no control over what divergent investment strategies you employ.
Risk: A golden rule does not exist for the proper investment allocation (equities, bonds, cash) as you approach retirement age. If you look at TDFs offered you will find that the glide paths of funds targeting the same date will differ. Some will have more exposure to stocks than others as the date approaches. What matters is that you are aware of the difference and comfortable with the choice you decide to make.
Secondly, as funds approach their target date, you will still be exposed to market risk. The problem is that when you have a down-turn comparable to the one experienced in late ’08 and early ’09, it’s difficult to find safety once things get ugly. When everyone runs for the exit at the same time, it’s difficult for anyone to get out the door unscathed.
Expectations: When evaluating for yourself or discussing a TDF with a planner, it is important to define a general set of expectations. The expectations I’m talking about are the returns to be expected throughout the various stages of the TDF’s life. No one knows for certain what the future holds, but a historical expectation should be set. For instance, you should know that between certain years you should expect to earn X-Y% annually.
Knowing what to expect from the TDF will allow you to gauge whether or not the expected performance plus your average annual contribution will bring you to the goal you envision by the target date. If the expected results put you in a vastly different spot than where you need/want to be, then you either need to adjust your expectations or the investment mechanism (TDF) you’re using. Know your expectations and where the TDF is projected to lead you before you invest and don’t forget to factor in the fees!
In closing, TDFs are a fine tool for investors seeking a more hands-off approach to their retirement investments, but investors must be willing to take the time and effort up front to ensure the TDF they’re investing in is correct for their situation. Do some extra work before you dive in so you won’t have to second guess yourself as you continually plow money into the TDF you selected.