6 Tips for Picking the Best Target Date Fund
By Ari Cetron
If you've given some thought to retirement savings, you've probably encountered target date funds. These mutual funds are age-based investment vehicles geared to the year you plan to retire so they automatically rebalance your assets as the target date approaches.
They can be owned outside a retirement plan, but because they are designed for retirement investing, they are often among the choices offered within 401(k)s and other retirement accounts.
These funds follow the conventional wisdom on investing: When you are further from retirement, they allocate more of your money to stocks to maximize returns. As you get closer to the magic year, the fund allocation becomes more conservative, shifting a greater portion of your assets from stocks to bonds and cash.
For people who want a more hands-off investment style, they can be an attractive way to save. However, target date funds aren't created equal and don't suit everyone. Here are six things to consider before you choose one.
1. Check the numbers. As is true with any sort of investment, past performance doesn't guarantee future performance. Still, it can be valuable to see the returns various funds are getting. A word of caution, these numbers can be skewed by the portfolio allocations. A fund with a higher percentage of stocks is more likely to have spikes in value if the stock market is having a good year. As always, look at results over time, which should help smooth out the differences.
2. What's your glide path? With any sort of investment, your personal tolerance for risk plays a role. In this case, the "glide path" will be a key component of the risk. Glide path is the lingo fund managers use to determine how quickly funds shift from stocks to bonds. For people in their 20s, most funds will place the vast majority, in some cases even 100 percent, in stocks. For folks a couple of years from their target date, the portion of funds in stocks may be closer to 50 percent, maybe even slightly lower. It's the in-between years, where they shift from one to another that can end up making a big difference in the balance in the end -- too soon and you could miss out on a bull run, too slow and a bear market could eat up lots of your savings.
3. When should it stop? There are basically two types of target funds. One type, called "to retirement," stops changing the stock-to-bond ratio once you hit the date, the other type continues to adjust as time goes on, called "through retirement." To-retirement funds end up being less risky at the expense of seeing your investments stop (or almost stop) growing when you hit the target date. Some experts prefer the through-retirement option, arguing that it's important to continue managing the balance as you age, rather than risk outliving your money.
4. What does it cost? Of course, there will be fees. But just because a fund has a higher fee, don't dismiss it outright. As with many things, you get what you pay for. A fund with a higher fee, but also with a higher return, may end up netting you more money in the end. As with everything, there are low-priced options that excel and high-cost flops. Do your homework.
5. How's it managed? Whether active or passive management is more successful in boosting returns is an ongoing debate among investors. Passive funds usually invest assets to reflect the makeup of a market index, thus tracking the ups and downs of that index. They provide broad market exposure and low operating expenses. The Dow Jones Industrial Average and the S&P 500 are two prime examples. They're not terribly exciting, but they take out a lot of the guesswork from investing. Generally, actively managed funds will cost you more, but they may net you a higher return, if you have the right manager.
Money Talks News founder Stacy Johnson is deeply skeptical of the value of these investment managers, as he explains in this article:
There's a mountain of evidence suggesting market timing is tough. For example, despite the fact that mutual funds employ both the smartest people and best technology on the planet, the average professionally managed mutual fund underperforms a simple, unmanaged index.6. Do you really need it? Basically, a target date fund helps shift your portfolio from stocks to bonds as you get older. It's something that you can probably do easily enough by yourself, or with the help of a financial adviser (especially if you're mostly in index funds anyway). Some people prefer the hands-off approach, they don't have to worry about rebalancing their investments every few years. But if you have the time and inclination to do the rebalancing yourself, you may do well to skip the target date fund and its fees altogether.
What's your experience with target date funds? Share with us in comments below or on our Facebook page.