Do you know about Target Date Funds (TDFs)? Do you own any? These vehicles continuing to gain in popularity, so it’s vital that you understand exactly how these investment accounts work. Grab a cup of coffee, please, because this topic will take two separate posts!
Target Date Funds are designed to “mature” in a given year and their percentage allocation of stocks and bonds depends on which TDF you have. For example, a 2030 Fund is supposed to be appropriate for someone retiring near the year 2030. (Makes sense, right?) For shorter time horizons thought, a nearer-date fund would be more appropriate. These options are supposed to take the guess work out of saving for retirement.
As with everything else in the investment universe, there are pros and cons. (In the next chapter, Part 2, we’ll get to some of my concerns; at the end of the day, I’m not a big fan of TDFs. But there are some definite advantages.)
The most appealing feature of TDFs is that they protect investors from themselves. Many individual investors simply do not have the time, patience, knowledge, or persistence to deal effectively with their investments over the long term. It’s confusing and emotional. Many investors don’t review their plans often enough (or don’t have a plan to begin with) and make rash decisions in the face of big market moves. TDFs, at the very least, provide the illusion of “everything is going to be all right.” So, people are less like to buy or sell at inappropriate times. Here’s an example of when a TDF may benefit you quite nicely. Let me begin with a quote from T. Rowe Price by way of money.usnews.com:
“During the market hysteria from the end of June 2008 to the end of May the next year, only 3.5 percent of target-date investors using T. Rowe Price funds changed their holdings, a rate only a quarter that of holders of non-target-date funds.”
This is good news! As you know, selling at market lows is the bane of many investors’ existence. Numerous studies have proved that there aren’t that many big up days, while there are plenty of big down days. Missing the dramatic moves upward will materially reduce your returns. So, a TDF should protect you during big market downturns, right? But if you were retiring shortly after the 2008 debacle, maybe your experience wasn’t so special. For example, T. Rowe Price Retirement 2010 lost 26.7% in 2008, while the average fund geared to those retiring in 2010 declined 22.5% (Forbes.com).
Let’s put that into perspective for a moment. If you were invested in one of these funds and entrusted this TDF to protect you with your retirement imminent, you got hurt badly. This is what we call, “Sequence of returns risk.” How your investments perform in the few years before and after you retire has a major impact on the longevity of your portfolio. (Sure, some may say that 2008 was a once-in-a-lifetime event, but didn’t we have a nearly identical decline back in 2001? I’m just saying!) So here are two advantages of TDFs:
TDFs generally have better returns than typical 401(k) plans
A 2014 study by Financial Engines, an investment-advisory firm, and Aon Hewitt, a consulting firm, found that investors who used TDFs earned 3.32 percent more per year than investors who managed investments on their own. That edge would produce a substantially larger nest egg over many years of compounding.
TDFs offer diversification and simplicity
Within a single fund, you get instant diversification across a wide range of asset classes, which typically include U.S. and foreign stocks, real estate investment trusts (REITs), government bonds, and corporate bonds. This can be a plus for unsophisticated investors who lack the time and energy to diversify their portfolios.
That’s just the way it works!
(Please stay tuned next week for part 2 of this scintillating series!)