Investing in Target Date Funds for Retirement

targetSaving for retirement is not as simple as putting X dollars into Y account and at age 65 receiving Z payment.  Stocks, bonds, annuities, interest rates, bull or bear market, the list goes on and on when it comes to factors to consider when investing for retirement.  One solution to this complex problem is target date funds.

A target date fund reallocates investments every five years.  This allows for a larger percentage of riskier but higher yielding stock investments when younger and a gradual shift to conservative and safer bond investments the closer to retirement.  For those looking for a safer path to retirement, the target date fund is the most popular way to keep a 401(k) in good shape.

A Hands Off Approach

Most financial experts recommend leaving retirement savings alone.  A basic “set it and forget it” approach to a managed fund account, like the target date fund, earns about 3% more in annual returns than those that are managed by individuals.  This small percentage can add up to thousands of dollars over the course of a lifetime.

Typically, the market fluctuates over time, but continues a steady increase in growth.  Don’t panic to short-term dips in the market.  Rather, look at the overall picture.  If you plan on working 30 or 40 years, don’t try to run a financial sprint, but relax and plan on a financial marathon.

Let the Autopilot Do the Flying

Many investors who are not confident in managing their investments prefer the target date fund because their asset allocations are automatically shifted to an age-appropriate mix the closer an investor approaches retirement.  The hands-off approach to this type of retirement investing has gained significantly in popularity over the last decade.  Assets held by target-date mutual funds have grown over $700 billion in the last ten years, proving that many investors prefer to let the target date fund autopilot steer their retirement plane.

Problems for Investors

Not everyone has the background, knowledge, or time to safely and confidently invest in the market.  Without the help of a financial expert, such as a certified financial planner, few retirement savers are able to successfully manage their own accounts and end up losing money over time.  For investors who use a financial planner, cost is an additional concern.  Target date funds traditionally have lower fees associated with them when compared to a managed fund.

What the Critics Say

Critics of the target date fund argue that an investor should actively move their investments as the market shifts.  According to these critics, every investor should be taking some risk in a bull market, especially a strong one, and no one should be risking their money in a bear market.  They argue that for younger investors, an active management approach is best due to the high percentage of investment in equities.  However, if the fund is not managed properly, or the market does not perform as predicted, then investors run the risk of greater loss than if they had invested in target date funds from the beginning.

Target Date Funds:  The Better Solution

Target date funds solve many of the problems those saving for retirement face.  The shift of asset allocation from stocks to bonds the closer to retirement positions investors for the best risk-adjusted asset class for their particular age group.  With an automatic shift in assets, expense ratios are lower.

With time, there is growing evidence that shows that an actively managed fund does not necessarily outperform a passively managed fund like a target date fund.  This shows in the large shift seen from active funds to passive index funds.

A Diverse Portfolio

Diversification of investments affords investors additional protection against risk.  With the population living longer, the additional demand for lifelong income has increased.  Some companies are now offering annuities as part of their target date funds.  With time and demand, it appears that many more funds will offer annuity payouts at retirement.

Many critics point to a lack of diversification in the location of target date funds.  They argue that U.S. stocks and returns on bonds are likely to decline in coming years creating a liability for target date funds.  However, with proper diversification, equity markets outside the U.S. should be chosen.  Choosing a target date fund that avoids a home-country bias is prudent.

Risk, Interest Rates, and Annuity Payments

Proponents of target date funds continue to argue that shifting funds every five years is advantageous to investors as they age, while critics argue that remaining in a default option target date fund is actually riskier and can lead to retirement crisis when investors outlive their money.  Additionally, they argue that the past three decades where bonds have shown strong returns cannot continue.  With interest rates predicted to increase after their historically low period, conservative bonds will lose value as interest rates increase.  

Annuity payments are also not advantageous when interest rates are low.  When inflation and increasing life expectancy is combined, annuity payouts are anything but safe.  Some suggest, instead of counting on annuity income in retirement, they should opt to roll their 401(k) into an IRA at retirement and purchase an annuity.

Finally, critics argue that those who are novices in investment need help in choosing the right investment program.  A tactical fund, managed by an active fund manager, can guide investors into taking more risk during an up market and less during a down market.  Instead of trying to predict what will happen, proponents of a tactical fund argue that investors should react to what is happening in the market currently.           

Whatever choices investors make with regards to their retirement savings, their final choice should be based on their individual needs at retirement.  

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