By Spencer Rand
Over the past few years, target-date funds have been growing in popularity. According to Morningstar's 2014 Target-Date Series Research Paper, estimated net flows in target-date funds tripled from 2007 to 2013, growing from $200 billion to $600 billion.
A target-date fund is a mutual fund that automatically changes its mix of stocks, bonds and cash based on an end date appropriate for a particular investor. In most instances, the date is viewed as the day someone will retire, although they don't have to be For example, someone aiming to retire in 35 years could choose a target date 2050 fund. Because it has a long horizon, the portfolio would likely be weighted heavily toward stocks and would gradually allocate more in bonds as time passed. Before you invest, consider these question.
1. How Much Control Do I Want Over My Investments?
If you consider yourself more of a hands-off investor and don't mind buying something and holding it for a long time, then target-date funds could be a good fit. They have built-in diversification between stocks and bonds; they automatically rebalance; and they are offered by companies that have been around for decades and oversee trillions of dollars, so you don't have to worry that it's not being managed by professionals.
%VIRTUAL-WSSCourseInline-459%However, if the answer to this question is "a lot," "some" or even "a little," then target-date funds probably aren't right for you. The biggest issue most people have with these funds is that you are letting someone else decide how to much invest in stocks and bonds over the life of the fund. What happens if, three years down the road, you change your outlook on the economy and you'd rather hold more bonds than stocks?
The only way to do this would be to sell your holding and buy a different target-date fund, which defeats the purpose of buying one in the first place. There's nothing wrong with entrusting someone else to choose how much to invest in stocks vs. bonds, but if you want any say in the matter, then it doesn't make sense to buy a target-date fund.
2. What Is the "Glide Path" for the Fund?
All target-date funds move to a more conservative allocation as the end date approaches, which is known as the fund's glide path. What's different is how they get there and what they do once you reach the end date. Some funds are designed to be nearly all cash once they hit the target date, and those types of funds are called "to retirement." They focus more on keeping your investments stable, since one of their main goals is to minimize the potential for loss of principal as of the end-date.
The other kind of target-date funds, known as "through retirement," are built for investors who want their money to stay in the market after you reach the target date. Being retired doesn't mean you don't need to continue to grow your assets, right? The advantage with this type is that it lowers the chance that you'll outlive the amount of money you have, which is known as "longevity risk."
3. How Important Is Tax Efficiency?
Let's assume you're retired and all of your investments are taxable. Owning a target-date fund can be tax-efficient from the standpoint that it typically has low turnover and some of its distributions may be taxed at the long-term capital gains rate, which is lower than the ordinary income rate. However, you miss out on other opportunities to reduce your tax bill.
For example, tax-sensitive investors like owning municipal bonds because the interest generated is not subject to federal income tax. Another way to lower taxes is with tax-loss harvesting. This is where you sell your holdings that are trading at a loss to offset any realized gains you have incurred. You wouldn't be able to take advantage of these methods if all of your money was tied up in a target-date fund. Of course, you can put some of your money and manage the rest on your own.
Spencer D. Rand, a chartered financial analysis, is an asset management associate at Monument Wealth Management, a financial advisory firm that helps accomplished entrepreneurs transition to a life of long-term financial independence and wealth defined on their own terms. Based in Alexandria, Virginia, Monument offers clients unbiased advice, true wealth planning, advocacy and access throughout the wealth creation life cycle.
By Spencer Rand